Proof That Share Buybacks are a Powerful Strategy for Building Wealth

The Curious Case of IBM Share Buybacks

This is an overlay chart of IBM’s stock price and its market cap since 2000. Do you notice anything interesting about this chart?

IBM share buybacks

IBM’s secret strategy for growing their stock price

 

Look closer…

The stock price and market cap have performed differently. How can that be? Aren’t they the same?

While the stock price and market cap are highly correlated, they are not the same.

Stock price – The stock price is the listed price based on what buyers and sellers are willing to pay for it.

Market (cap) capitalization – The market cap of a stock is the stock’s price per share times the number of shares outstanding.

Market Cap = Stock Price per share   x    # of shares outstanding

In general, the stock price and market cap of publicly traded stocks are highly correlated. However in the case of IBM, since 2000 the market cap went from $200 billion dollars to a recent market cap of $158.4 billion dollars. This is a decrease of 20.80%. This means the value of the entire company, if you were going to buy every share, has declined in the past 15 years.

The price of the stock went from $113.41 in 2000 to $163.9 as of today. This is an increase of 44.52%. or a 65.32%. If you bought shares of the stock in 2000 and held until today, not including dividends paid out, you would have made 65.32% on your investment despite the fact that the company’s market cap was 20.80% less during that period of time.

How is this possible?

IBM Share Buybacks in the past 15 years

The reason that shareholders have made money in IBM while the company declined in value is due to share repurchases by the company. Here is a sheet showing the market cap and stock price year to year for the past 15 years. The red is years where the amounts dropped and the green is years where the amounts grew.

stock share repurchases

(Click on the picture to see the details)

 

What you will notice is that in every year except for two, a number of shares outstanding has dropped. This is why the stock price has outperformed the market cap over the past 15 years. While IBM share repurchases may benefit shareholders long term, there is no guarantee that the company will be able to continue to support the same amount of share repurchasing that they have for the last 15 years. Many companies in the S&P 500 are using this same strategy of repurchasing shares since it can have both a positive effect on the stock price and earnings per share.

Why do share buybacks benefit shareholders and the company?

stock share buy backs

Think of the company as a round pizza. Let’s say that you decide to cut it into 10 slices in order to feed 10 people. However, only 8 people show up and want to get fed? What do you do? You can cut it into 8 slices instead of 10. Each slice will now be bigger because there are fewer of them. A company’s share repurchase plan works in much the same way.

There is a certain amount of profit that the company produces annually. This profit is split up evenly among the shares outstanding. If there are 10 shares outstanding, then each person will get 10% of the profits. If there are only 8 shares, then each person will get 12.5% of the profits.

A company repurchasing its shares allows the company to grow on a per share basis, even if its revenues and profits are not growing. So if a company consistently produces a similar amount of free cash flow, and they use it to repurchase shares of the company stock, then it will increase the value of each share outstanding.

Continuing with the IBM share repurchase example, IBM’s total revenue in 2000 was about $88,396,000,000. At the end of 2014 the revenues hit $93,358,000,000. This is a growth rate of 5.6%. Yet the shares of stock outstanding dropped from 1,818,240 to 989,660,000. This is a 45+% drop in the number of shares outstanding.

Do companies like IBM engage in financial engineering?

This post is not about whether IBM is a good or bad stock to invest in. You will have to seek advice from your own financial advisor to answer that question. However IBM a great example of how companies “manipulate” their numbers. I have read many articles about how IBM is manipulating their numbers, and engaging in financial engineering. These articles always describe financial engineering with negative connotations. The basis for their claims is that the company is buying back shares in order to grow their earnings. I don’t see how that is a bad thing. If anything, it is quite the opposite.

Buying back shares is the company’s way of giving you a tax-free dividend. If the company were to pay you a $4 annual dividend, you would have to pay taxes on that dividend. If they used that $4 to buy back shares, it should theoretically increase the value of your shares by $4. While this might not matter to someone who is trading a stock for short periods of time, long-term buy and hold investors will benefit greatly from this type of strategy.

In the past 10 years, companies have really picked up the pace of their share buybacks. I would not call this financial engineering, but rather good capital allocation. Whether buying back shares is the best use for their capital is another conversation on a different day. What is important is that the company’s capital is being used to benefit the shareholder.

company share buybacks

Share buybacks are only part of the formula for the shareholder yield strategy. They are a powerful and tax-efficient way to invest. However, if you want to maximize the shareholder yield concept, you will need to find stocks that employ all of these components. To learn more about the shareholder yield strategy, you can read:

What you should take away from this post is that share buybacks are a good thing for both the shareholders and the company. Some of the reasons are listed in the articles above. There are many important factors to consider when investing in stocks. This is only one of them. Keep reading the blog to learn about other shareholder-friendly uses of a company’s free cash flow.

 


Sources:

GuruFocus


About Innovative Advisory Group: Innovative Advisory Group, LLC (IAG), an independent Registered Investment Advisory Firm, is bringing innovation to the wealth management industry by combining both traditional and alternative investments. IAG is unique in that they have an extensive understanding of the regulatory and financial considerations involved with self-directed IRAs and other retirement accounts. IAG advises clients on traditional investments, such as stocks, bonds, and mutual funds, as well as advising clients on alternative investments. IAG has a value-oriented approach to investing, which integrates specialized investment experience with extensive resources. 

For more information, you can visit  http://www.innovativewealth.com

About the author: Kirk Chisholm is a Wealth Manager and Principal at Innovative Advisory Group. His roles at IAG are co-chair of the Investment Committee and Head of the Traditional Investment Risk Management Group. His background and areas of focus are portfolio management and investment analysis in both the traditional and alternative investment markets. He received a BA degree in Economics from Trinity College in Hartford, CT.

Disclaimer: This article is intended solely for informational purposes only, and in no manner intended to solicit any product or service. The opinions in this article are exclusively of the author(s) and may or may not reflect all those who are employed, either directly or indirectly or affiliated with Innovative Advisory Group, LLC. This is not intended to be a recommendation of the stock(s) mentioned in this post. The stocks mentioned are only intended for informational purposes. 

 

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