The value and benefits, or lack thereof, of share buybacks to the future fortunes of a company and their shareholders is one of the most hotly debated subjects on popular financial blogs such as Seeking Alpha.  Unfortunately, at least based on my own personal experience, most of the arguments are predicated on opinions and beliefs in lieu of the facts.

Consequently, the primary thesis behind this article is to provide a more fact-based discussion regarding the desirability of share buybacks devoid of emotional or opinionated arguments.  Stated more directly, my objective will be to answer the question posed in the title of this article: to buy back shares, or to not buy back shares, that is the question.

My Inspiration Was Not Positively Instigated

My inspiration for penning this article, which I feel was long overdue, came as a result of a loyal reader of my work sharing a rather one-sided, prejudicial and opinionated article on share buybacks that he/she read on MorningStarAdvisor.  The article was authored by Rex Nutting of MarketWatch on April 24, 2015 with the provocative title “Update: How the Stock Market Destroyed the Middle Class.”  From my perspective, this article represents a classic example of an opinionated and prejudiced argument lacking a factual representation as evidenced by the following provoking excerpt:

[drizzle]“But one under-appreciated factor is a pervasive business model that encourages top managers of American corporations to loot their company for short-term gains, depriving those companies of the funds they need to build and enlarge, and invest in their workers for the long haul.

How do they loot their company? By using large stock buybacks to manage the short-term objectives that trigger higher compensation for themselves. By using those stock buybacks to manipulate the share price, which allows them to use inside information to time their own stock sales. By using buybacks to funnel most of the company’s profits back to shareholders (including themselves).  They use the stock market to loot their companies.”

In my opinion (pun intended) this article clearly expressed the author’s negative and prejudiced opinion and view of share buybacks while simultaneously alleging that they are destructive to the economy and the middle class.  There were facts presented, and I’m going to accept that they were accurate; however, I do not accept the fact that they supported his economic destruction thesis.  The reader can form their own opinions by following this link to the entire article found here.

The truth is that share buybacks are neither good nor bad in their own right.  Under certain circumstances and in certain instances, share buybacks can be a very bad or poor use of corporate capital.  Under other circumstances and instances, share buybacks can be the most prudent and beneficial use of corporate capital.  Therefore, prejudging all share buybacks as bad or destructive is just as wrong as holding prejudiced views or judgment about people based on race, creed or color.

When Share Buybacks Are Good and When They Are Bad

In his 2011 letter to shareholders of Berkshire Hathaway, renowned investor Warren Buffett wrote extensively on his and partner Charlie Munger’s position on share buybacks.  Here is a link to the full letter, but what follows are a few important excerpts that relate to the subject of this article:

“Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.”

Personally, I believe that Warren Buffett succinctly hit the nail on the head with this one sentence.  However, the first condition can be very difficult to accurately assess, and admittedly open to some debate.  On the other hand, that is not to say that it cannot be properly evaluated, it just takes a little work and digging under the hood of a company, the competitive landscape of its industry and its business model to correctly ascertain.

The second condition is easier to determine and evaluate, and represents the primary financial subject that I have dedicated my professional life to-sound valuation.  It is a prudent, sound and long-term profitable tactic when a company can repurchase shares at sound and attractive valuations.  In contrast, share repurchases can represent a very unsatisfactory and destructive use of capital when valuations are unsound or high.  In the same letter, Warren Buffett had this to add on the subject:

“We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another. (One CEO who always stresses the price/value factor in  repurchase decisions is Jamie Dimon at JPMorgan; I recommend that you read his annual letter.)”

Interestingly, Warren Buffett then went on to use one of his large holdings, International Business Machine (IBM), as his example to illustrate his points more comprehensively.  I found this interesting for a couple of reasons.  First of all, because I am also long IBM, and because I authored two articles on the company found here and here that created quite a stir and large and lively comment threads.

The second reason I found this interesting, is based on the date in which Warren Buffett made the comments (his 2011 letter) and the subsequent corresponding share buyback behavior of IBM’s management team.  Next I will share Warren Buffett’s comments on IBM and its management relative to their share repurchases behavior, and then I will provide factual evidence utilizing the F.A.S.T. Graphs™ fundamentals analyzer software tool to provide supporting evidence of the veracity of his words.

“Let’s use IBM as an example. As all business observers know, CEOs Lou Gerstner and Sam Palmisano did a superb job in moving IBM from near-bankruptcy twenty years ago to its prominence today. Their operational accomplishments were truly extraordinary. But their financial management was equally brilliant, particularly in recent years as the company’s financial flexibility improved. Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock.

Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.

Let’s do the math. If IBM’s stock price

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