The power of stock buybacks for creating shareholder value

After setting a torrid pace in 2022—followed by a somewhat quieter 2023—U.S. companies are back in the business of stock buybacks. S&P Dow Jones Indices has projected that companies in the S&P 500 Index will repurchase some $885 billion worth of their own stock in 2024, which would represent a 10% increase from last year and a 4% decline from 2022’s record total.

But with lingering uncertainty about the economy’s durability as well as new questions about the timing of future interest-rate cuts, are share buybacks an effective allocation of capital in environments like today’s?

Stock buybacks are a time-tested means of increasing shareholder value

There are any number of things a company can do with earnings: organically reinvest, retain the cash, or distribute some of those earnings back to shareholders. The most common means of returning earnings to shareholders is by paying a dividend, but companies can also decide to buy back shares, which increases existing shareholders’ proportional ownership. For example, if a hypothetical investor owns 1% of a company that repurchases 5% of its shares outstanding annually for five years, the investor’s ownership stake would increase by almost 30% without any incremental capital.

There are several reasons why a company would want to deploy capital to buy back shares. For companies that pay out dividends, fewer outstanding shares means the same pool of money can be distributed among a smaller base of shareholders—and that can increase the level of income for individual recipients.

"On a longer-term time frame, the compounding effect of a declining share count can unlock significant value for shareholders."

Reducing a company’s cash on hand through repurchasing shares can also boost certain closely watched financial metrics, such as return on invested capital, as well as earnings and free cash flow on a per share basis. These types of metrics are essentially fractional calculations: By reducing the denominator in each (through share buybacks), the result increases even though the numerator is unchanged. It might seem academic, but improving these types of financial metrics can act as a tailwind for a stock and ultimately help drive prices higher. On a longer-term time frame, the compounding effect of a declining share count can unlock significant value for shareholders.  

Case study: how an auto parts retailer turbocharged its stock performance

A U.S.-based auto parts retailer provides an illustration of the potential power behind steady earnings growth paired with consistent share repurchases. In the late 1990s, the company’s management team recognized that its capital needs were relatively low, so the team elected to direct all the company’s free cash flow to shareholders through repurchases. Since then, the company has reduced its net shares outstanding by more than 90%. While the 6% average revenue growth and 10% net income growth that the company recorded over that time frame weren't remarkable, the firm stood out by posting more than 20 consecutive years of positive earnings growth. By continually repurchasing shares while steadily growing its bottom line, the company’s earnings per share (EPS) have expanded over the past 25 years at a compound annual growth rate (CAGR) of around 20%. Similarly, the stock compounded at approximately 20% annually over those 25 years, resulting in an 85-fold cumulative gain.

Had the company not consistently repurchased shares over that period, its EPS would have grown at a mere 10% CAGR, according to our calculations. Applying the stock’s mid-February 2024 EPS valuation multiple, the stock would similarly have been almost 90% lower than its share price at that time had the company not engaged in share buybacks.

Stock buybacks can be a better creator of shareholder value

In many cases, share buybacks are a more efficient way to return capital to shareholders than dividends, provided the company appears to have reasonably durable future earnings growth and a reasonable valuation. One reason is the comparative flexibility that buybacks offer. When it comes to dividends, companies are often penalized for cutting or suspending their payments and generally take pains to avoid doing so. Companies that offer a high dividend payout ratio (as a percentage of EPS or free cash flow) can find themselves essentially handcuffed to those dividend payments and unable to pursue other options that may deliver higher returns versus a dividend—especially during volatile periods, such as aggressive share repurchases or opportunistic acquisitions.

Dividends have drawbacks for investors as well. They’re relatively inefficient from a tax perspective, as dividends are subject to double taxation—first at the corporate level, when the income is earned, and then at the individual level, when the income is received. Dividends also introduce reinvestment risk in that distributions may be able to purchase less and less of a stock that continues to appreciate over time.

What the performance numbers show about buybacks and shareholder yield

In an effort to quantify the importance of buybacks, we compared the performance of the top quintile of dividend-yielding stocks across the U.S. equity market (as represented by the Russell 3000 Index) with the returns of the top quintile as measured by total shareholder yield, which factors in both dividends and buybacks.

We found that the addition of buybacks alongside dividends significantly enhanced those stocks’ total returns over every time period we looked at. Our conclusion: The dividend-paying stocks of companies that are the most active at buying back shares have consistently generated stronger returns than stocks that return most capital solely through dividends. 

^{Source: Boston Partners, March 2024. Dividend yield is a dividend expressed as a percentage of a current share price. Total shareholder yield is the sum of the stock’s direct payments to shareholders through dividends plus indirect payments such as buybacks as measured by the percentage decrease in a company’s outstanding shares. The Russell 3000 Index tracks the performance of 3,000 large-, mid-, and small-cap companies in the United States. It is not possible to invest directly in an index.}

As for where to find those companies engaged in share buybacks, investors can look at shareholder yield, which incorporates both dividend payments and repurchase programs. We’ve found it’s not always the case that healthy dividends correlate to an attractive total shareholder yield; communication services and financials, for example, are two of the leading sectors in terms of shareholder yield, but aren’t necessarily known for their robust dividend payouts.

^{Source: S&P Dow Jones Indices, March 2024. Dividend yield is a dividend expressed as a percentage of a current share price. Total shareholder yield is the sum of the stock’s direct payments to shareholders through dividends plus indirect payments such as buybacks as measured by the percentage decrease in a company’s outstanding shares. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index.}

The importance of buybacks in stock selection

From an investment perspective, we believe it’s preferable that businesses with relatively low capital needs return capital to shareholders through share repurchases and/or dividends, absent a higher returning use of that cash for expansion or acquisition. Typically, the incremental return on capital of expansion or acquisition is less that what’s gained through purchasing shares, assuming the valuation of repurchased shares is attractive. Our experience has shown that investing in the stocks of companies that have consistently repurchased shares offers the potential for a powerful compounding effect on returns over the long term, particularly among companies with healthy balance sheets and stable revenue streams.