How buybacks distort price-to-book ratios


Share buybacks can boost earnings per share (EPS) but hamper book value growth. Many investors use price-to-book ratios to find undervalued stocks, and this is where they can run into valuation issues.

Buybacks, also known as stock buybacks, can skew results, making price-to-book a useless measure of many stocks’ valuations. The companies that regularly reduce their share count through buybacks can appear overvalued on a book value basis.

This article examines why buybacks are a favorable outcome for EPS growth, but typically lower book value per share and slow the growth of this asset-based metric.

The central theses

  • Share buybacks tend to increase earnings per share (EPS) but slow book value growth.
  • If shares are repurchased above the current book value per share, this reduces the book value per share.
  • Buybacks reduce outstanding shares, causing a company to appear overvalued.
  • A cash repurchase results in a decrease in cash and therefore a decrease in equity on the balance sheet, with no corresponding gain in other assets.
  • Investors should consider earnings per share and return on equity (ROE) growth and price-to-book ratios in light of any artificial buyback effects.

What does a buyback look like?

Book value is defined as a company’s total assets less total liabilities (ie debts). The book value per share is the total book value divided by the number of shares outstanding.

The price-to-book ratio compares a company’s market capitalization to its book value. The calculation is a company’s stock price per share divided by its book value per share.

Let’s look at an example that shows how buybacks affect the earnings per share and book value per share of a large company that is conducting a large one-time buyback.

XYZ Corporation: Pre-Repurchase

  1. Total assets $300 billion – total liabilities $150 billion
    Book value = $150 billion
  2. Book value $150 billion / outstanding shares $1 billion
    Book value per share = $150
  3. Annual profit $20B / outstanding shares $1B
    Earnings per share = $20
  4. EPS $20 / book value $150 per share
    Return on Equity = 13.3%

Suppose XYZ’s stock is trading at $200 per share and XYZ repurchases half of all its stock (500 million total) or $100 billion worth of shares. In the real world, this would happen over several years at varying rates, but to illustrate, let’s assume it all happened at once.

XYZ Corporation: Post buyback
Note: $100 billion in cash was spent to purchase 500 million shares at $200 per share.

  1. Total Assets $200 billion – Total Liabilities $150 billion
    Book value = $50 billion
  2. Book value $50 billion / Shares after buyback $500 million
    Book value per share = $100 per share
  3. Annual profit $20 billion / shares after buyback $500 million
    Earnings per share = $40 per share
  4. EPS $40 per share / book value $100 per share
    Return on Equity = 40%

Note that if the shares are repurchased above the current book value per share, the book value per share will decrease. If the stock was trading below book value, which is rare, the company could have increased its book value per share through a buyback.

There are several ways that a buyback might show up on a company’s balance sheet, depending on several factors, but to keep it simple let’s assume XYZ bought back the shares with cash and then retired the shares. It’s like they burned the shares never to be re-issued. This results in a reduction in cash and hence a reduction in reported equity with no corresponding gain in other assets.

There are other, more complicated ways a company might handle the buyback reporting, such as: B. Issuing debt securities and holding the repurchased stock as treasury stock.

How should you interpret buyback results?

As you can see in this example, there is a large bias in the book value per share due to a larger share buyback being higher than the current book value per share.

Management may initiate share buybacks when it believes the company is undervalued and are optimistic about its future business.

Buybacks improved EPS from $20 to $40 but reduced book value per share from $150 to $100. Also note that the return on equity (ROE) measure jumps from a more normal 13.3% to a staggering 40%. ROE numbers can make a normal deal look exceptional, but should be viewed as an accounting anomaly when a major buyback occurs.

How do buybacks affect finances?

Dollar Tree (DLTR) is a company that has had stock buybacks on a regular basis. Let’s examine what these buybacks have done to the financial metrics.

In 2003, Dollar Tree Stores earned $177.6 million. In 2007, that number rose to $201.3 million, an increase of 13.3%. During the same period, Dollar Tree’s earnings per share rose from $1.54 to $2.09, a 35% increase. How did Dollar Tree do this? It did so through the financial magic of share buybacks. Now let’s look at the cause of these strange results.

Dollar Tree’s share count increased from 114 million to about 90 million shares through share repurchases, down 21%. While EPS grew tremendously from these buybacks, book value didn’t fare as well. It grew just $2.35, or 26%, from $8.90 per share to $11.25 per share, while total EPS earned by Dollar Tree was $7.06.

It’s important to remember that every dollar of revenue doesn’t always add to book value, although in theory most of it should. This assumes no
Dividends are paid, which is the case with Dollar Tree. Dollar Tree’s earnings were generally used to buy back stock each year, along with the normal expenses of expanding the business.

The final result

Using price-to-book as a measure of value, you need to be careful when a company has bought back shares. How can you tell if this has happened? Look at the company’s total number of shares over the consecutive years.

The best solution for an investor is to look at EPS and ROE growth and price-to-book ratios in light of any artificial buyback effects.


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