- When a company buys its own shares and you have confidence in the quality of that company's management, chances are that the stock is undervalued, and you should expect the stock price to rise over time.
- On the other hand, if the repurchase of stocks seems to be motivated by a desire to reduce the number of shares and, hence, increase earnings per share, you should avoid investing in the company.
When a publicly traded company buys its own shares, the outcome is a smaller number of shareholders owning the business. Through repurchases, the company may signal that its shares are undervalued. The academic literature supports the view that companies repurchasing their own shares are frequently undervalued.
"Firms repurchase stock to take advantage of potential undervaluation."
Investors can infer that a company that repurchases its shares frequently is unlikely to waste free cash flow in unproductive acquisitions.
"Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value of each $1 expended."
Coca-Cola decided to invest its cash flows in itself by purchasing some of the shares back. From 1989 to 1999, the number of the company's common shares outstanding decreased from 2.79 billion to 2.49 billion - a drop of 11 percent, or about 1 percent per year. At current prices in 2009, this amounts to about $1 billion annually.
Companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value.
By making repurchases, when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders.
Investors should pay more for a business that is lodged in the hand of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer.
Sometimes, share repurchases can boost reported earnings because the number of shares go down due to repurchasing. Before investing in a company that is repurchasing its own shares, you should investigate the company fundamentals and its management quality.
The annual letter to Berkshire shareholders on March 11, 2000 further clarified Buffett's thinking on share repurchases:
"There is only one combination of facts that makes it advisable for a company to repurchase its shares:
- First, the company has available funds - cash plus sensible borrowing capacity - beyond the near-term needs of the business, and,
- second, finds its stocks selling in the market below its intrinsic values, conservatively-calculated."
If profitable investment opportunities exist, then management should not repurchase the company shares even when the price is attractive. This is probably one reason Buffett did not choose to repurchase Berkshire shares.
Investors should also consider the potential value added. Buffett continues,
"A purchase of, say, 2% of a company's shares at a 25% discount from per-share intrinsic value produces only a 1/2 % gain in that value at most."
Thus, when management reputation is well established, as in Buffett's case, the advantage in repurchasing may not be substantial.
Buffett further emphasizes his interest in shareholder wealth:
"Please be clear about one point: We will NEVER make purchases with the intention of stemming a decline in Berkshire's price. Rather we will make them if and when we believe that they represent an attractive use of the Company's money."
Overall, if a company purchases its own shares on a regular basis and its fundamentals appear sound, you should consider buying shares in the company.