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What do Share Buybacks have to do with Earnings Per Share?

When the recent Tax Reform came out at the end of last year, pundits predicted that companies would put tax savings towards share buybacks.  These companies would repatriate money that had been stowed overseas to shelter them  from the higher U.S. tax rates. Once back in the U.S. they will use that money to either increase dividends, invest in their business or repurchase their shares. This has begun to happen, and we have begun to see a huge increase in share buybacks.

When companies announce share buybacks, they do so with great fanfare. They will say that the company management feels that the shares are undervalued, and will be a wise use of this capital. Additionally, in any marketplace, when you essentially inject demand into the supply and demand equation, prices (in this case share prices) should inch up in the short term.

What they rarely ever say is, “with these share buybacks, we will be able to increase our Earning per Share faster.” Earnings per Share is the ultimate company measuring stick. In theory it measures how fast a company is growing their profits, and it is the measure most closely watched on Wall Street, and reported during earnings season. Brokerage Research Analysts base their earnings estimates off of the historical Earnings per Share (or EPS). Their estimates try to predict how fast these earnings will grow in the future.

When a company purchases share buybacks, they reduce the number of shares outstanding. In turn, this will factor into all “Per Share” ratios. For example, Earnings per Share is a formula in a very simple sense:

Earnings per Share = Company Earnings   / Total Shares Outstanding

By buying shares back, essentially the Total Shares Outstanding decreases, and by reducing the denominator, you increase the other side of the equation. I apologize for the algebra!

As an investor, you would far prefer EPS to be driven by increasing Company Earnings. That is growth you can see into the future. So for the next year or two, while the impacts of the tax reform are working their way through the system,  it is worth looking under the EPS covers, to see whether a company’s earnings growth is driven by share buybacks or by organic growth.