Share buybacks: are we getting value for money?
Share buybacks have become hugely popular in recent years. By buying back their own shares and then cancelling them, companies can engineer an increase in earnings per share in excess of any increase in total profit.
In theory, the resulting increase in both earnings and earnings growth will support a higher share price and a higher price-to-earnings (P/E) rating.
If carried out correctly, share buybacks can represent an attractive investment opportunity for a business and its shareholders. But as I’ll explain, this is not always the case. Other motivations may drive some executives’ buyback decisions.
The sums of money committed to buybacks are often large and can exceed the cost of a company’s annual dividend. This means shareholders are swapping potential cash special dividends for the less certain benefits of a shrinking share count.
I think it’s worth considering more closely what buybacks mean for shareholders and how we can gauge whether they are likely to represent an attractive use of a company’s capital.
Dividend vs buybacks
A dividend is a cash payment that you or I will receive in our brokerage account. This payout reduces the book value of the company in line with the amount of cash spent, but shareholders are no poorer. We have our share of this cash and can do with it as we wish.
A dividend is truly a return of capital to shareholders. The same description is often applied to buybacks, but I think this is somewhat misleading.
When a company buys back its own shares, it expends cash, but shareholders do not receive it.
In theory, the benefits of the buyback will mean that the remaining shares become more valuable, both in terms of their market price and their intrinsic value. However, reality often falls far short of this rose-tinted ideal.
Consider drinks giant Diageo (LON:DGE), historically seen as a good stock for long-term investors.
Between June 2021 and June 2023, Diageo spent £3.7bn buying back 98.8m shares at a weighted average cost of 3,708p. Very roughly, that was about 160p per share, equivalent to a yield at the time of about 4.3%.
Shareholders could have received that cash, but they didn’t. Today, the company’s shares are trading over 35% lower, at 2,335p.
Diageo’s net debt has risen by around £2.7bn since June 2021, arguably because of the buybacks.
With interest payments now approaching 15% of operating profit, I don’t think these buybacks have yet created much value for shareholders.
Misaligned incentives?
Indeed, we might speculate that buyback decisions are sometimes motivated by management’s own personal incentives, rather than a desire to deliver genuine shareholder returns.
Executive bonus schemes are often linked to earnings per share growth. Buybacks boost eps growth, even if profits stay flat. Buying back shares can also help to offset the dilution caused by generous stock option schemes.
In contrast, shareholder returns might be better served by other capital allocation choices. Leaving dividends aside, companies might instead opt to use buyback cash to invest in new growth or repay debt.
In the right circumstances, both options might support stronger shareholder returns over time.
When is a buyback a good idea?
What we need as investors is an objective method of gauging whether a share buyback is an attractive use of capital at the current time.
In the remainder of this article, I’ll look at two simple methods we can use to analyse share buybacks and answer these key questions:
What’s the expected return from a share buyback ?
What is the maximum price a company should pay to buy back its shares?
Calculating the expected return
When boards consider capital allocation choices, they should look carefully at the expected return on capital employed.
If an investment of £100m will generate a £15m annual profit, then it achieves a 15% ROCE.
A similar principle can be used to gauge the likely return from a buyback. This is often referred to as the effective rate of return.
As with many things, Next (LON:NXT) has long provided other companies with a benchmark to follow for buybacks. The FTSE 100 retailer uses a simple effective return calculation to decide whether to allocate surplus capital to dividends or buybacks:
“Any share buybacks would be subject to achieving a minimum 8% equivalent rate of return (ERR). As a reminder, ERR is calculated by dividing anticipated NEXT Group pre-tax profits by the current market capitalisation.”
Next FY24 final results
I agree with the 8% return target for a big cap stock like Next, but I would suggest applying it with respect to trailing 12-month pre-tax profits instead. PBT forecasts are not always readily available, but we can always calculate a trailing 12-month PBT using the results available on the Income tab of the StockReport.
Following this approach with Diageo suggests that buybacks at current levels might be attractive:
Current market cap: £52,290m
FY24 pre-tax profit (y/e 30 June 2024): $5,460m
Convert to GBP at $1.27 = £4,299m
4,299/52,290 = 8.2% pre-tax effective rate of return
Unfortunately for shareholders, Diageo has had to pause its share buybacks this year to protect its balance sheet, after years of buying back shares at much higher prices.
What’s the maximum price a company should pay?
Next’s method is a quick and simple way to gauge the potential return from a buyback plan. But it can be useful to go one step further and calculate the maximum price a company can pay in order to achieve a minimum rate of return.
This process is slightly more complex, but still relatively straightforward.
For this example, I’ve used Diageo again. In the 23/24 financial year, the company completed a $1bn share buyback at an average price of 2,874p.
I want to know what the maximum share price was that Diageo could have paid while still meeting Next’s 8% ERR target:
Required return: 8%
Buyback amount: $1bn
Increase in profit required: 1,000*0.08 = $80m (buyback x req’d return)
EPS increase required: 1.46% (increase in profit / FY24 pre-tax profit of $5,460m)
% of company shares to buy back: 1.44% (1 minus (1/1.0146))
No. of shares to buy: 32.04m shares = 2,458p per share
Diageo’s current share price is 2,335p, so once again we see that buying back shares today could be a good deal for shareholders.
Unfortunately, the average share price of 2,874p paid in FY24 would only have given an ERR of 6.7%.
That’s not disastrous; I’ve seen much worse. But it’s worth remembering that Diageo has a five-year average ROCE of 15%:
Viewed in this context, I’d argue the company might have been better off reinvesting the capital in the business or repaying some debt, rather than buying back its relatively expensive shares.
Other considerations
For faster-growing businesses, some investors will argue that buybacks make sense because the benefits will compound over time. A 3% ERR today might become a 10% ERR at some point in the future.
Mathematically, this argument can be made to stack up in some situations, particularly for true high-quality compounders that can deliver long-term growth.
The risk is that the future is inherently unpredictable. There’s a real risk that cash spent on high-priced buybacks will never generate satisfactory returns.
I prefer not to sign up to investments that rely on long-term growth to achieve satisfactory returns. But that’s a personal choice, reflecting my relatively conservative risk appetite.
However, whatever your view on buybacks, I think it makes sense to evaluate them and understand the potential financial returns they offer. After all, it is ultimately your cash the company is spending.
Disclaimer
This is not financial advice. Our content is intended to be used and must be used for information and education purposes only. Please read our disclaimer and terms and conditions to understand our obligations.
26 comments
I am a believer that the board of a company should publish their estimate of intrinsic value and hence should whether a buyback is accretive or not.
I think too many boards / managements bamboozle with 'it is accretive' with a lack of evidence.
Furthermore using debt to fund a buyback increases leverage and risk and therefore the equity risk premium for the company should go UP and hence the valuation ought to go DOWN. Surprising how many boards do not seem to realise this.
Companies tend to finance acquisitions and pay for dividends with debt when rates are low and liquidity is plentiful. When things reverse however they often find that they lack the financial headroom and the cheap funding that their strategy was dependent on.
I think that looking too intensely at the US is inappropriate. The behaviour / reaction to dividends and buybacks is also driven by tax structures (dividends are taxed higher than capital gains - and there are state as well as federal taxes to consider). It gets more complicated in the US for a whole variety of reasons but the bottom line is that long term capital gains are a lot more attractive.
I think in the UK with the recent changes in capital gains tax and dividend tax rates we may face investors wanting more buybacks.
If I have looked it up right: US ordinary income tax is 39.6% at the highest rate vs 20% for capital gains.
In California the highest state income tax rate is 13.3%.
So a Californian high net worth would pay circa 52.9% tax on dividends whilst on CGT it would be 20% (and obviously the individual decides when he or she needs the money).
See https://en.wikipedia.org/wiki/... and https://en.wikipedia.org/wiki/...
There may also be county income taxes (or City) in some counties see https://taxfoundation.org/rese...
[Note I am not an expert on US Taxes]
Thanks for a fabulous article Roland on an important topic which I see has also prompted some high quality discussion. Personally, I’m not a fan of buybacks most of the time but I accept there is a valid counter view.
Moreover, I wish there was a way that we could save articles like this for easy reference in the future but alas, I fear it wil get lost in the ether.
Whitbread (LON:WTB) announced a share buyback on 16 October, 2024 the share price went up about 8% that day and then rose on the following days. The shares will either be cancelled or held in treasury.
The share price has fallen back since. I was looking to sell anyway, l managed to get out near the peak, so if the rise was solo due to the buyback, then that was better, for me, than paying it out as a dividend.
"The shares will either be cancelled or held in treasury."
This is the annoying part. Cancelled is fine. Held in treasury is not fine as they are likely to be exhumed for directors' benefit later - definitely not for shareholders
Some companies operate in areas where growth is harder and for them dividends make sense
Whitbread (LON:WTB)
any reasons for selling Rusty2?
I have been buying in at 2900 or below - with very little debt and great brand and great tnav backing - this seems a very very defensive share at present to be buying into.
I guess p/e is probably about 13 now and forecasts have been dropping and may drop further if they have cost issues (NI hikes) - so perhaps one can get in cheaper and perhaps whilst trend in expectations is downwards i am somewhat going against the flow here - but its still chunky profits being made and to me with such little debt they should have plenty of excess cashflow to pimp up returns even if organic profit growth is anemic.
Unless the RNS makes it clear that the shares will be cancelled, it is very likely that they will be given to the directors. Occasionally they might be given to all employees as part of an employee share ownership plan.
Great article and very insightful and practical. Only one question: What’s the rationale and justification for using 8% ERR and not some other number? Is there any underlying math that derives the 8% for Next that would allow us to calculate the equivalent figure for any other company?
8% is close to double the rate of what a AAA rated bond would have paid you over 10 years (and by extension 30 years), historically
the historical rate being 4.3%-4.4% for US treasuries. the UK's is - IIRC, don't quote me! - closer to 4.1%-4.2%
(although the UK is no longer AAA rated lolol)
but yes, that would be my guess. 8% return on share buy-backs gives a chunky margin of safety (ben g. approved) over buying AAA sovs./govs.
How do you know, what the share price would be, if the company had not done the buybacks? If they pay out a dividend then the share price falls. I don't think they should do buybacks if they have high debt.
The large US stocks do backbacks and their shares have soared and they pay no or little dividends.
Probably a controversial observation in the light of other comments, but I’m all for share buybacks. They halve the tax payable on the alternative and are an effective DRIP scheme. Big Ashtead (LON:AHT) USD 1.5bn buyback announced today is just what I wanted to see after a frustrating TU. It expresses confidence in the future and increases the value of my holding should growth re-accelerate.
Sometimes they don’t work in the short term, as the share price continues to fall. But you always have the option to sell the company at any point to halt the drift. And at a higher SP than if the buyback had not occurred. And stop kidding yourselves. Do you always get it right when you reinvest dividends from one company in another? Pick winning businesses that grow over the long term and their buybacks will reward you.
If you don’t like them then you’re probably investing in the wrong company/market for buybacks to work, ie ex-/low-growth UK options. Fortunately, we all have a choice.
It’s not a controversial observation BnB as buybacks are very popular, and many just take it as read that they work well.
Re your “sometimes they don’t work in the short term” comment; often they don’t work long term either. And if we invest in successful businesses that don’t opt for buybacks we can win big with those too. I like well managed Companies that invest in the business successfully rather than spending that money on buybacks.
Finally to your claim that the share price will be higher than if no buybacks had occurred. There’s no evidence to support that comment. Buybacks are not factored in when buy and sell prices are being set and then fluctuating throughout the day. They can’t possibly be.
I do wonder in todays markets with EFTs and trusts being challenged with redemptions that buybacks are a way of reducing sell overhangs quicker
Well balanced article.
BnB UK investors will never understand the value of buybacks unless they turn their attention over to the US , where real growth profitable companies execute them. Apple (NSQ:AAPL) amongst hundreds of others have their share count slashed by half over the last 10 years!
What exactly is a dividend? Nothing else but a board of directors telling their shareholders that they cannot use that cash for growth!
Not sure if it’s Goldman Sachs (NYQ:GS) that has a detailed explanation about how British American Tobacco (LON:BATS) have waisted all these dividends instead of choosing buybacks , explaining that the price should have been X5 by now.
Across the pond if a company opts for a dividend instead , it is regarded as a sin! And they have shown as the last 20 years how proper value is created for shareholders.
All the best
Yes.Apple (NSQ:AAPL) is an example of well executed buybacks. So is Next (LON:NXT.
It’s wrong to claim that all buybacks are bad.
It’s just as wrong to claim that all dividends are wrong too.
Look at Games Workshop (LON:GAW) . They paid £4.10 in dividends this year. The share price was only a bit over that £4.10 just 8 years ago. Anyone who bought then (I did but sold far too soo) now gets almost 100% reward from dividends every year!
AND the Games Workshop (LON:GAW) share price has multi bagged 30 times in just 8 years to the current £140. 30 bagging share and a 100% yield.
Please tell us what is wrong with that yiannos.
Here’s the dividend data link for GAW’s dividends:-
https://www.dividenddata.co.uk...
I think the performance of shares like Games Workshop (LON:GAW) makes a nonsense of your claim that “dividends are nothing else but a board of directors telling their shareholders that they cannot use that cash for growth.”
John Lee, the first ISA millionaire, holds shares paying him more than 100% a year in dividends.
Finally the big Mining Companies used to spend multiple £billions buying back their shares. That was ahead of the extraordinarily severe Mining bear market that ended in 2015 that saw their shares fall as much as 80% despite those huge buybacks. So they now go for dividends and big special dividends in the good years and not buybacks.
Shareholders and indeed management can't be always confident spare cash will be used wisely to invest. A number of companies in the tech sector grow by acquisition, and this is a potentially fraught area of expectation, as many will have experienced in some individual companies. Turnover growth is cold comfort when profits are damaged.
As in all things it depends on a balanced approach. Assuming a company is not increasing its share count, and therefore not really relying on the markets to raise capital, but is both investing its cash in its operations, and rewarding its investors in the meantime, that seems a happy medium of sorts. With lower interest rates momentum is maintained by dividends in a slightly stalled market.
Are dividends stagnating the dynamism of the UK market? Its certainly an interesting talking point.
Insightful piece, Roland. To me buybacks often feel like a poor substitute for dividends or growth investment. They risk rewarding exiting shareholders or boosting executive metrics, rather than creating tangible value for long-term investors. In many cases, I find them underwhelming and have even seen share prices decline as a result.
Great article Roland. I hate buybacks for the following reasons:
1. I don't like being told I'm getting a shareholder reward when potentially I'm getting a zero, or a minus.
2. I want to decide when a company's shares are good value. That's my job. My part of the deal. I don't want someone else deciding that for me.
3. Shares are often bought back only to be held in treasury rather than cancelled. They can then be wheeled out later to supply option schemes etc.
The share buyback fad gives management some sly options. Just pay me the dividend instead thanks. I have uses for it.
Thanks doctor Dave - to your point 3 is there a way of knowing whether a company has cancelled or held in treasury? Would both show a change in share count?
This is normally declared at the time but my experience is that at times it can be deliberately opaque. Cancelled shares do reduce the total share count yes.
Couldn't agree with you more, often used by directors to increase their chances of a bonus. Ineffective mgt in my view
My favourite was Likewise (LON:LIKE)
Last of the big spenders.
Share Buyback Programme- Likewise Group plc (AIM:LIKE), the fast growing UK floor coverings distributor, announces that it intends to conduct a share buyback programme of ordinary shares of £0.01 each in the capital of the Company ("Ordinary Shares") up to a maximum aggregate consideration of £250,000
That was a superb and balanced article on buybacks Roland. What a shame though that it has only had 88 reads and no replies other than a deserved thank you post.
Why the lack of interest on such a big issue?
Possibly 2 reasons:-
1. There’s a general assumption that all buybacks are good so why bother reading an article on them.
2. The usual thing; people only reading and posting on the Daily Stock Market Report thread and before that the daily small company thread. So many excellent threads on Stockopedia get far too little recognition.
To Roland’s article. imo there’s nothing in it to challenge . That’s a rarity for me with buyback articles.
A few key points:-
1. Buybacks are not the “ return of capital” nor a “reward to shareholders” that so many just take for granted that they are. If the share price goes UP, that’s a “reward to shareholders.” That applies whether or not that Company is buying back shares.
If the share price goes DOWN that is not a “reward to shareholders.” It’s loss of capital, which either worsens or is fully recovered or more if the share price recovers. Again this applies regardless of whether or not that Company is buying back their shares.
2. A dividend is always a “reward to shareholders,” as the shareholder, unlike with buybacks, gets a genuine cash return.
3. Buybacks do reward those who want to sell as there’s a willing buyer (the Company buying back) of their shares.
4. Buybacks often reward Company Managers if their bonus payments are based on eps. Buybacks DO increase eps. But that doesn’t always mean a rising share price. It’s just higher eps than would have been the case without the buybacks. But Companies buying back can disappoint with profits warnings and (albeit rarely) a 100% loss.
5. Buybacks are often greeted with a big share price rise and positive commentator comment on the day they are announced. I sometimes sell on the day a buyback is announced as often that initial bounce is followed by share price falls as investors take advantage of selling being easy to do.
6. Roland used Diageo (LON:DGE) as an example of big share price falls post buyback. This is surprisingly frequent. I’ve held dozens of shares over the years that have “rewarded me with buybacks” where the share price not only fell, but where the falls were big and relentless.
e.g Abrdn (LON:ABDN) when 6 years ago they started their £multi million buyback programme and continued it for over 5 years. They started their buybacks at £5. I sold as the share price dropped below £4.50. The falls have been relentless ever since until recently bottoming at £1.30.That’s far worse than Diageo. Over 70% share price fall for Abrdn (LON:ABDN) I bought back Abrdn (LON:ABDN) too soon a couple of years ago around £1.60 but still escaped most of the share price loss. No way did those who decided to stay invested get a “reward” from their disastrous buybacks. Those who sold were the ones who did best.
7. Again as Roland pointed out buybacks CAN work well when done sensibly with Roland’s Next (LON:NXT) example a clear cut case. They only buyback when the share looks good value. Too many Companies buyback regardless of whether or not the share looks too cheap.
8. Some prefer to see Companies buyback than use that money (as Aviva (LON:AV.) is doing now , to invest in the business for fear that investment in the business might go wrong. It might. But so too often do buybacks! Successful Companies find good value businesses to invest in.
9. Buybacks can show lack of imagination and ambition. Is investing £ multiple millions and even £multiple billions for some big Companies buying back their shares the best that Company can think of to invest their spare money?
10. Finally. There are plenty of examples of Companies that have bought back heavily later having to come back to their shareholders for more money via Rights Issues or dilutive placings. e.g the big Banks bought back heavily ahead of the Banking crisis, and Lloyds Banking (LON:LLOY) for one then had to have 2 Rights Issues in quick succession.
I'm also not a fan of buybacks (for the reasons Ken outlines), as well as:
Buybacks (without cancelling the shares) are often used to swell employee reward schemes (especially in US)
Buybacks reward exiting shareholders, I'd rather hold and collect divis thanks!
On Aviva (LON:AV.) and possibly Legal & General (LON:LGEN) and other insurers which are paying big dividends, if their cost of borrowing is less than the dividend yield, would it not make sense to buy back, as it would reduce the total cost of capital (at least in the short term and assuming capital cannot be used for growth)?
Excellent, informative and clearly put across as always Roland, many thanks