Prime Numbers: The true value of share repurchases

As we have written before, share buybacks can boost a company’s earnings per share (EPS), which can support some managers’ desire to hit (badly designed) compensation targets.1 But remember, the increase in EPS is not the point of share repurchases, nor does it suggest an overall increase in value.

To understand why, consider the following example. A company’s operations earn €94 million annually and are worth €1.3 billion. The company has €200 million in cash (for a total value of €1.5 billion), on which it earns interest of €6 million. Setting the tax implications aside for now, what happens if the company decides to use all its excess cash to repurchase its stock—in this case, a total of 13.3 million shares (exhibit)?

Since the company’s operations don’t change, neither does the value of its operations. But the company’s equity is now worth only €1.3 billion, as there is no cash left. Its EPS increases because the number of shares has fallen, but its share price remains the same. The total company value has fallen in line with the number of shares. Note, the effect would be similar if the company increased its debt to buy back more shares.

Essentially, we’re left with an operating company with a P/E of 13.8 and cash with a P/E of 33.3 (the cash balance divided by interest earnings). Once the excess cash is paid out, the P/E will go down to that of the operating company. The change of EPS and P/E is purely mechanical; it is not linked to value creation.

Even when corporate taxes are part of the equation, the company’s value increases by only a very small amount because its cost of capital falls from having less cash or greater debt (unless, of course, there is a major refinancing).

Some share repurchases may see an announcement effect. Through the buyback, senior managers may signal that, in their mind, the stock is undervalued. Or they may project confidence that the company doesn’t need the cash to cover future commitments, such as interest payments and capital expenditures. But before any announcement even occurs, it will likely be obvious to most shareholders that a lack of cash investment opportunities is not the main driver of share repurchases.

The bottom line? Share repurchases are a good way to return cash to those who can invest it better than a company at the limits of investment capacity, for whatever reason. But buybacks don’t fundamentally create value.

1. Richard Dobbs and Werner Rehm, “The value of share buybacks,” McKinsey, August 1, 2005.

Vartika Gupta is a solution manager in McKinsey’s New York office, where David Kohn is an associate partner; Tim Koller is a partner in the Denver office; and Werner Rehm is a partner in the New Jersey office.

For a full discussion of market dynamics, see Valuation: Measuring and Managing the Value of Companies, seventh edition (John Wiley & Sons, 2020), by Marc Goedhart, Tim Koller, and David Wessels.

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