More and more UK companies are buying back their own shares. Data collected by Russ Mould, investment director at AJ Bell, shows share buybacks at FTSE 100 companies are running at an aggregate value of £18.3 billion so far in 2024.

Despite being only two months into the year, the value of buybacks already equates to 35% of the whole value of buybacks in 2023.

This isn’t just a UK phenomenon either ─ according to fund group Janus Henderson, global buybacks have almost tripled since 2012, outpacing dividends.

Consequently, the importance of share buybacks has increased. In 2012 global buybacks were 52% of dividends. By 2022 the ratio had increased to 94%, ranging from 18% in emerging markets to 158% in the US.

The figures are inevitably skewed by large companies, with Apple’s (APPL:NASDAQ) $89 billion of purchases equating to 7% of the global total in 2022.

Share buybacks have been popular in the US for many years but until recently were little used in the UK. According to wealth manager Schroders (SDR), 13% of large UK companies bought back at least 5% of their shares in 2023 compared with 9% in the US.

WHY DO COMPANIES BUY BACK SHARES?

Buying back (and subsequently cancelling) shares has the effect of reducing the number of shares outstanding.

This means annual profit is divided between fewer shares which produces an uplift in EPS (earnings per share) for remaining shareholders. The same effect is seen on dividends per share.

The effect is purely mechanical and has no impact on the underlying value of a business. Cash flow and profit remain unchanged.

Selling shareholders receive cash, while remaining shareholders benefit because they now own a biggest share of the distributable profit.  

A working example using retailer Next (NXT) is provided later in the article.

A study by McKinsey & Co in 2015 looked at 250 companies in the S&P 500 index between 2004 and 2014 and found no relationship between buybacks and total return (capital gain plus dividends) for shareholders.

This probably reflects misuse of share buybacks which is discussed later in the article.

Scrutinising management’s use of buybacks is important for shareholders trying to figure out if shareholder value is being created or not.

Remember, buying back shares is but one choice management teams have for allocating surplus cash, alongside paying out dividends, reinvesting in the business, making acquisitions or paying down debt.

WHY UK FIRMS ARE EATING THEMSELVES

One reason for the increasingly popularity of share backs is the low valuation of UK shares.

Managers Ian Lance and Nick Purves at value-focused trust Temple Bar (TMPL) sum up the situation as follows:

’Some of the largest market participants in the UK have been allocating away from UK equities, which are close to all time low valuations, and therefore should have the potential to offer attractive returns.

‘Instead, investors are allocating to US equities, at close to all time high valuations, a level which has historically been associated with poor returns.’

More UK managements are seeing the value of using surplus cash to make share repurchases in addition to paying out dividends.

Fund managers at Artemis say companies are buying back shares ‘at a rate we have never seen before’.

In the past year 57% of companies by value in the Artemis Income Fund (B2PLJH1) have bought back shares, says the manager.

Some UK examples are stark: oil major BP (BP) has reduced its share count by 16% in just over 18 months, while NatWest (NWG) has reduced its share count by 22% in under two years and housebuilder Berkeley (BKG) has reduced its share count by 30% since 2016.

DOUBLE-EDGED SWORD

Buybacks can be a double-edged sword, however, because shareholder value can be destroyed as well as enhanced depending on the price paid for the shares in relation to the intrinsic value of the business.

As Warren Buffett explains in his annual letter (24 February): ‘All stock repurchases should be price dependent. What is sensible at a discount to business-value becomes stupid if done at a premium.’

The problem is intrinsic value is a slippery beast and hard to nail down with any precision. Another Buffett quote is useful here: ‘It is better to be roughly right than precisely wrong.’

John Barr Williams first came up with the idea of calculating business or intrinsic value using discounted cash flows in his book The Theory of Investment Value published in 1938.

His work has influenced many value investors, including Buffett, who wrote in his 1992 shareholder letter: ‘In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: ‘The value of any stock, bond, or business today is determined by the cash inflows and outflows-discounted at an appropriate interest rate-that can be expected to occur during the remaining life of the asset.’

NOT ALL BUYBACKS MAKE SENSE

Some investors are sceptical of share buybacks and favour dividends instead. Nick Clay, head of equity income at fund manager Redwheel, reveals some of the banana skins which await unsuspecting adherents of buybacks.

He argues most buybacks happen near market tops and end up destroying shareholder value. At market bottoms when buybacks make more economic sense they disappear, and worse still are replaced by share issues which further dilute shareholders.

A second drawback for Clay is many buybacks are made to offset dilution of share-based compensation. A related issue is when companies conduct share buybacks to trigger bonuses or stock options.

One final important criticism Clay makes is when buybacks are made with borrowed money which is a no-no in his mind, or when cash is used which could otherwise have been invested in the business to create greater value.

Clay concludes: ‘Dividends represent an equal distribution to all investors, be they longer-term investors or employees or pension funds.

‘Everyone receives the same per share distribution. Dividends as a means of returning value to shareholders is statistically advantageous for investors, truly aligned to their long-term objectives in a manner of equality.’

Dividends and share buybacks are taxed differently with the former treated as income and the latter capital gains. Some investors may have a preference based on the tax treatment.

One final consideration to be aware of is that companies do not always carry through with announced buyback programmes and sometimes do not cancel the shares purchased. Instead holding them in treasury.

This is another reason why some investors prefer dividends because cutting them or reducing them sends a stronger message to shareholders than stopping a buyback. 

Disclaimer: Financial services company AJ Bell referenced in the article owns Shares magazine. The author of the article (Martin Gamble) and the editor (Ian Conway) own shares in AJ Bell.

SHARE BUYBACK EXAMPLE

Retailer Next (NXT) has been buying back shares on a regular basis over the last decade as well as paying dividends.

Next’s management has shrunk the number of shares outstanding by around 17% over the last decade, equivalent to around 2% a year.

Underlying post-tax profit has grown at a CAGR (compound annual growth rate) of 2.8% a year. Reducing the number of shares has had the effect of increasing the CAGR in EPS to 5.1% a year.

In addition, the company has seen a 5% CAGR in dividends per share.

Next explicitly states it will only purchase shares if it can achieve what it calls an 8% equivalent rate of return. This is calculated by dividing anticipated pre-tax profit by the current market valuation.

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