Warren Buffett: The Only Time Share Buybacks Make Sense

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 stock selling in the market below its intrinsic value, conservatively calculated.
-- Warren Buffett, 2000 

Investors love share buybacks. When a company buys shares of its own stock and retires them, it leaves fewer shares outstanding. This boosts earnings per share, because the company's net income is spread over fewer shares. Additionally, the buyback program tilts the supply demand balance for the stock in favor of sellers, which can push the share price higher.

Warren Buffett believes that share buybacks make sense only when two key conditions are fulfilled.

However, buybacks don't always make sense. Investing legend and Berkshire Hathaway CEO Warren Buffett has said that two conditions must be fulfilled for share buybacks to be a good use of capital. The company must have excess cash and borrowing ability to fund the buyback, and the stock needs to be clearly undervalued.

Unfortunately, not all management teams are as savvy as Warren Buffett when it comes to share repurchases. For example, Netflix executed a poorly conceived buyback a few years ago, which has cost present-day shareholders more than $1 billion.

When do share repurchases make sense?

In the quotation above, Warren Buffett explains when share buybacks make sense -- and when they do not. The first key ingredient is adequate liquidity. Some businesses have minimal capital requirements, but others require high capital investments. Making necessary investments is critical to a business's long-term health -- skimping in order to buy back shares could erode competitiveness.

Additionally, while it sometimes makes sense to borrow money in order to repurchase shares, that's only true up to a certain point. Buffett points out that it is important not to take on an unwieldy debt load to fund buybacks.

The second requirement is that the stock must be selling for less than its "conservatively calculated" intrinsic value. In other words, a company's management should take a sober look at its future business prospects and stock price compared to those of competitors. Unless the stock is clearly undervalued, a buyback is the wrong way to go.

These two requirements are significant hurdles, but they are certainly not insurmountable. In late 2011, Berkshire Hathaway announced a share buyback program that was expressly guided by Buffett's two key principles.

Netflix's buyback gaffe

Netflix's behavior in 2011 demonstrated the cost of ignoring Buffett's buyback criteria. In early 2011, Netflix management openly admitted that the company was not "price sensitive" when it came to buybacks. Whenever executives felt Netflix had excess cash, they used it to repurchase stock, regardless of the price.

Netflix didn't follow Warren Buffett's buyback rules in 2011.

That clearly violates Warren Buffett's second rule for stock buybacks. According to Buffett, Netflix executives should have made some effort to ensure that they weren't overpaying. Alternatively, Netflix could have returned cash to shareholders through dividends.

As it turned out, Netflix's management team also did a poor job of calculating its excess cash. In the first three quarters of 2011, Netflix spent approximately $200 million to repurchase 900,000 shares of stock. However, Netflix's subscription price increase that summer caused a customer backlash, while the company's international expansion turned out to be very costly.

With more obligations looming and an uncertain path to profit recovery, Netflix decided to raise money that fall. It sold 2.86 million shares at $70/share, for a total of $200 million. Between the buyback in the first three quarters of 2011 and the share sale in Q4, Netflix essentially gave away 2 million shares (worth over $800 million at today's market price).

Netflix also issued $200 million of convertible debt in late 2011. This eventually converted to another 2.3 million shares (worth about $1 billion today: a gain of nearly $800 million for the holder). By spending freely on share buybacks when it should have been bolstering its balance sheet, Netflix was forced to raise capital on extremely bad terms, costing shareholders more than $1 billion.

Foolish final thoughts

Properly executed buybacks can create plenty of value for shareholders. A company that repurchases its stock for less than its intrinsic value makes all of the remaining shares more valuable. However, a poorly executed buyback can just as easily destroy shareholder value: a lesson that Netflix's management learned the hard way.

For other management teams trying to decide whether to buy back shares, Buffett has some simple rules to follow. First, don't spend beyond your means -- make sure you have more than enough cash and borrowing ability to run the business properly. Second, don't buy back shares unless they are clearly undervalued.

Investors should thus be cautious when a company announces big buyback plans. If it seems like the company has thoughtfully evaluated its cash needs and the stock's intrinsic value, it may be good news. If not, then the chances of a good outcome are much lower.

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