Chloe Smith, Fund Manager, Sanford DeLand considers share buybacks and whether they are a smart investment or a short-term fix.
Are share buybacks a smart strategy for enhancing shareholder value, or a quick fix that might be masking underlying weaknesses?
This has been a long-standing topic of debate in financial markets. While proponents argue buybacks create value for shareholders, critics claim they simply flatter financial performance and come at the cost of reduced future investment in the business itself.
Nevertheless, buybacks remain a key tool for returning value to shareholders, something that is particularly relevant in the current UK market, where share prices have been subdued in recent years.
What are share buybacks and why do companies conduct them?
As the term suggests, share buybacks are where a company buys back its own stock, typically from the open market or occasionally directly from shareholders. This reduces the number of outstanding shares a company has, which increases the ownership stake of the remaining shareholders. A company may choose to do this for many reasons, one common motive being to return excess capital to shareholders when there is no immediate need for it in the form of dividends, reinvestment, or acquisitions.
Buybacks are often seen as a signal that a company believes its stock is undervalued and can create shareholder value if the shares are purchased for less than their intrinsic worth. Buybacks also provide flexibility of timing and can be a good signal as management are the ultimate insiders, so have a greater insight into their prospects than the typical investor.
The EPS debate
Reducing the share count can help to boost financial measures such as Earnings per Share (EPS) as profit is spread over fewer shares, enhancing the company’s apparent profitability. This is where controversy often arises. Critics argue that share buybacks artificially inflate EPS and, by extension, share prices in the short term. This concern is compounded when EPS increases benefit management through performance-based bonuses, as EPS is often a key metric tied to compensation.
Buybacks in practice
Currently, over 40% of the investee companies in our funds are engaged in buyback programmes, a trend that reflects a wider increase in buyback activity across the UK stock market. In recent years, there has been a notable increase in share buyback activity, particularly among UK-listed companies, to manage their capital efficiently and support shareholder value – especially amid undervalued market conditions in the UK.
To assess whether a company’s improved financial performance is driven by buybacks or actual earnings growth, investors should closely examine net income growth at the headline level. If EPS is growing significantly faster than net income, it indicates that share buybacks are likely the key driver.
For example, property platform Rightmove has been conducting share buybacks since 2007 as a means of returning surplus capital to investors. Over the past 15 years, its reported profit after tax has grown at a compound annual growth rate (CAGR) of around 13%, while EPS has grown at a CAGR of 16%. This suggests the buybacks are not solely inflating EPS, but are accompanied by actual earnings growth. As a capital-light business, Rightmove has limited capital expenditure needs, allowing it to return significant free cashflow to shareholders via buybacks without sacrificing its return profile.
There is a further positive of share buyback programmes of course. Shares cannot be purchased with fresh air and only those companies with strong free cash generation have the capability to fund them sustainably. In this sense, a buyback programme can itself be a positive indicator of strong financial standing.
So, are buybacks a smart move?
Share buybacks serve as a significant lever for companies to pull as part of their overall capital allocation framework. When used responsibly, they can provide a meaningful boost to shareholder value, particularly during periods of low valuations – as seen in the UK today.
However, investors should remain vigilant. While buybacks can enhance financial performance, they must be supported by genuine earnings growth to deliver lasting value.
By closely examining net income trends and understanding a company’s capital allocation strategy, investors can better assess whether buybacks are a sign of strength or a short-term fix.
In the right circumstances, buybacks can reinforce financial stability, reward shareholders, and reflect management’s confidence in the company’s future prospects.
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