In his book, Investing For Growth, Terry Smith discusses how to ensure share buybacks add value for shareholders. Here’s an excerpt from the book:
Simply by executing a share buyback rather than paying out dividends, companies can inflate their earnings per share (EPS) and are almost universally seen to have created value for shareholders when mostly they clearly have not.
Capital allocation decisions are amongst the most important decisions which management of companies make on behalf of shareholders. Yet share buybacks are not sufficiently understood by company investors and commentators, and maybe even by company management.
One of the most important facts that is continually overlooked is share buybacks only create value if the shares repurchased are trading below intrinsic value and there is no better use for the cash which would generate a higher return.
Most share buybacks destroy value for remaining shareholders, and management is able to get away with this as the current accounting for share buybacks conceals their true effect. So what needs to change?
1. Management should be required to justify share buybacks by reference to the price paid and the implied return and compare this with alternative uses for the cash.
2. Investors and commentators should analyse share buybacks on exactly the same basis as they would if the company bought shares in another company.
3. Investors and commentators should use return on equity to analyse the effect of share buybacks rather than movements in earnings per share.
4. Share buybacks need to be viewed with more than average scepticism when done by companies whose management are incentivised by growth in EPS.
5. Accounting for share buybacks should be changed so that the shares remain as part of shareholders’ funds and as an equity accounted asset on the balance sheet in calculating returns.
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