Buybacks are one of the biggest developments in stock markets over the last decade, but do they actually add value? In this article we examine why companies are buying back shares and shrinking their capital rather than reinvesting for growth.
Typically, when a company announces a buyback its shares rally as it is seen as a sign of management confidence. Generally, the bigger the buyback the bigger the response, even if the shares are overvalued and the timing is poor.
A zero-sum game
Buybacks mechanically boost a company’s EPS (earnings per share), because afterwards there are fewer shares in issue. Therefore, in theory, the profits attributable to each remaining share rises, but that doesn’t mean the value of the company rises.
If a company has one billion shares trading at 100p, it has a market value of £1 billion. If it buys back 20% of its shares, that leaves 800 million shares worth 125p each on paper, so the valuation is still £1 billion.
The value of the company’s operations doesn’t change just because there are fewer shares in issue. All that changes is the value of the shares because there are 20% fewer in circulation.
The change in EPS is purely mechanical, so it doesn’t create any value either. In other words, on paper, buying back shares is just a zero-sum game. But if it adds no value, why do so many companies buy back shares rather than paying more dividends?
Why do companies buy back shares?
Historically, companies used buybacks as a more tax-efficient way to return cash to shareholders than dividends. However, with many UK retail investors using tax wrappers like SIPPs and ISAs, tax efficiency is less of an issue.
Companies usually claim buybacks ‘create shareholder value’, but as we can show they don’t add any value to the business. Instead, they divert money from dividends which are a valuable source of income for many investors.
All companies have – or should have – a capital allocation policy which is clearly stated in their accounts. This lists the order in which they prioritise the allocation of capital which is surplus to their needs.
Top of the list, usually, is reinvesting in their own business, assuming it makes an attractive return. Every company with a high return on invested capital should first and foremost reinvest in its business.
Second on the list is either finding earnings-enhancing acquisitions to grow the business, or repaying debt to reduce financial costs. Either of these is a good use of surplus capital as long as the firm has high hurdles regarding acquisitions.
If a company doesn’t need to invest, it has no debt and/or it can’t find any attractive acquisitions, it might return cash to investors. This could be through an increase in the regular dividend, a one-off ‘special’ dividend or a share buyback.
However, some companies use buybacks as a way to inflate earnings and the share price to meet incentives or pay-related targets. Others do it as a way to project confidence when in fact it means they face a lack of investment opportunities.
Disciplined management with an understanding of intrinsic value may be able to buy back shares at an attractive level. But working out why a company is buying back its own shares can often require a bit of detective work.
No buybacks here, thank you
A good example of a company which shuns buybacks is construction and office fit-out firm Morgan Sindall (MGNS). The business is highly cash generative, ending last year with a net cash pile of over £500 million.
In its capital allocation framework, the firm prioritises a strong balance sheet with a cash ‘buffer’ in the event of a recession. Next comes investing in its core business, followed by ordinary returns to shareholders, then acquisitions.
CEO John Morgan is very clear about keeping cash to invest in the business given the market opportunity facing it. Therefore, ‘special’ returns to shareholders are at the bottom of the list and would only be considered in extremis.
Another company which eschews buybacks is Warhammer miniatures maker Games Workshop (GAW). The firm invests its surplus cash in opening new retail stores, maintenance spending, new tooling and working capital.
As the business has become more successful, Games Workshop has found itself with cash which is truly surplus. It doesn’t have an ordinary dividend policy, so it makes special payments over the course of the year.
Falling into the buyback ‘trap’
One of the problems with buybacks is, once a company starts down that road it can be hard to stop. Investors get used to the idea, and often just the announcement of a buyback can prompt a pop in the shares.
When money gets tight, however, buybacks can be the first thing a company decides to do away with. Take oil giant BP (BP.), which spent over $32 billion on buybacks between 2021 and 2025 or around $6.5 billion per year.
In February, the company suspended its buyback because it accepted it simply couldn’t afford it. Weak oil prices and a weak dollar mean its cashflow has shrunk dramatically and it desperately needs to conserve capital.
British Gas owner Centrica (CNA) has come to the same conclusion and suspended its buyback programme, much to investors’ disgust. Meanwhile, Shell (SHEL) is maintaining its buyback almost in defiance but we suspect it too will announce a cut eventually.
Hotel group Intercontinental (IHG), owner of the Crowne Plaza and Holiday Inn brands, is in something a buyback quandary. Last year it returned $1.1 billion to investors through buybacks and shares, but it had to borrow money to do it.
In other words, it increased its debt to buy back its own stock because investors expect it. This doesn’t strike us as a sensible commercial decision, rather it’s a desperate attempt to keep shareholders from checking out.
Some companies have even seen their shares drop despite maintaining a commitment to buybacks. Asia and emerging market focused bank Standard Chartered (STAN) saw its shares fall despite promising to buy back $1.5 billion of its own stock.
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