Share buybacks or repurchases can be a boost to corporate earnings per share (EPS) but they can also be a drag on book value growth. Many investors use the price-to-book (P/B) ratio to find undervalued stocks and they can run into valuation problems when companies carry out buybacks. Companies that regularly reduce their share count through repurchases may appear overvalued on a book value basis.
Buybacks have a favorable result for EPS growth but they typically lower the book value per share (BVPS) and slow the growth of this asset-based measure.
Key Takeaways
- Share buybacks or repurchases tend to boost earnings per share (EPS) but they slow book value growth.
- It lowers the book value per share when shares are repurchased above the current book value per share.
- Buybacks reduce the shares outstanding and this results in a company looking overvalued.
- A cash buyback results in a decrease in cash assets and therefore a decrease in shareholders’ equity on the balance sheet with no corresponding gain in other assets.
- Investors should look at growth in EPS and return on equity (ROE) as well as price-to-book value.
What Does a Buyback Look Like?
Book value is an accounting valuation that’s defined as a company’s total assets minus total liabilities or debt. Book value per share is the total book value divided by the number of shares outstanding.
The price-to-book (P/B) ratio compares a firm’s market capitalization to its book value. A company’s market price in the stock market will often greatly exceed its book value because a company’s stock is worth more than just the value of its assets. Companies have brand value, human capital in their employees, intellectual property, and other intangibles that are often worth more than the company’s physical assets.
A low P/B is therefore a signal to value investors that a company’s shares may be undervalued because they don’t fully account for those other things. P/B can be gamed by a company’s managers using buybacks, however.
Let’s look at an example of how buybacks affect the earnings per share and book value per share of a super-sized corporation doing a large one-time buyback.
XYZ Corporation: Pre-Buyback
- Total assets $300 billion – Total liabilities $150 billion
Book value = $150 billion - Book value $150 billion / Shares outstanding 1 billion
Book value per share = $150 - Annual earnings $20 billion / Shares outstanding 1 billion
Earnings per share = $20 - EPS $20 / Book value $150 per share
Return on equity = 13.3%
Assume XYZ’s stock is trading at $200 per share and XYZ buys back half of all its shares, 500 million in all or a total of $100 billion in shares. This would take place over several years at various prices in the real world, but let’s assume for illustration purposes that it all happens at once.
XYZ Corporation: Post-Buyback
$100 billion of cash assets was spent to buy 500 million shares at $200 per share:
- Total assets $200 billion – Total liabilities $150 billion
Book value = $50 billion - Book value $50 billion / Shares post-buyback 500 million
Book value per share = $100 per share - Annual earnings $20 billion / Shares post-buyback 500 million
Earnings per share = $40 per share - EPS $40 per share / Book value $100 per share
Return on equity = 40%
It lowers the book value per share when the shares are repurchased above the current book value per share. The company could have raised its book value per share through a buyback if the stock was trading below book value but this is rare.
A buyback could show up on a corporate balance sheet in several ways depending on several factors but we’ll assume that XYZ repurchased the shares with cash on hand to keep it simple. XYZ then retired the shares as though they had burned the shares, never to be issued again. This results in a decrease in cash assets and therefore a decrease in shareholders’ equity on the balance sheet. There’s no corresponding gain in other assets.
Note
A company could handle the reporting of the buyback in other more complicated ways such as issuing debt and holding the repurchased shares as treasury stock.
How Should You Interpret Buyback Results?
There’s a major distortion of book value per share due to a major share repurchase done above the current book value per share number.
Buybacks improved the EPS from $20 to $40 but they lowered book value per share from $150 to $100. The return on equity (ROE) measurement goes from a rather normal 13.3% to an astounding 40%. ROE numbers can make a normal business look extraordinarily good but they should be viewed as an accounting abnormality when a major buyback occurs.
Important
Management might enact share buybacks if they feel that the company is undervalued and they’re bullish on its future operations.
Despite criticism, share buybacks by U.S. corporations have been increasing over the past decade.
Do Buybacks Affect the Price-to-Earnings (P/E) Ratio?
Yes. A buyback reduces the number of shares outstanding so it will make the amount of earnings greater per share given fewer shares to spread the earnings among. This results in a boost to earnings per share (EPS), lowering the P/E ratio of a company.
What Is a Good Price-to-Book Ratio?
A good P/B ratio will depend on the company’s growth stage and its industry sector. P/Bs under 1.0 are considered good and could point to a potentially undervalued stock. Value investors often consider stocks with a P/B value to be under 3.0.
Do Share Buybacks Create Value?
Share buybacks may increase the price of a stock but they also reduce the number of shares outstanding. Economists have found that buybacks don’t create value by increasing EPS. They may deplete a company of cash that it could otherwise use for more profitable investments or projects.
What Are the Reasons for Buyback of Shares?
A company may buy back shares of its stock in the open market if it has too much extra cash lying around that it can’t find a better use for or if it perceives the market to be undervaluing its shares. Companies may also engage in buybacks for tax reasons or as a defense against a hostile takeover attempt.
The Bottom Line
Be careful if a company has been buying back stock if you use the price-to-book ratio as a measure of value. How can you tell if this has happened? Look at the company’s total share count over successive years.
The best solution for an investor is to look at growth in EPS and ROE as well as price-to-book value, in the light of any artificial effects from buybacks.
Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.