How Buybacks Warp the Price-to-Book Ratio

Share buybacks (repurchases) can be a boost to corporate earnings per share (EPS), but can be a drag on book value growth. Many investors use the price-to-book (P/B) ratio to find undervalued stocks, and this is where they can run into valuation problems when companies carry out buybacks. Companies that regularly reduce their share count through repurchases may thus appear overvalued on a book value basis.

This article will examine why buybacks have a favorable result for EPS growth but typically lower the book value per share (BVPS), slowing the growth of this asset-based measure.

What Does a Buyback Look Like?

Book value is an accounting valuation defined as a company's total assets minus total liabilities (i.e. debt). Book value per share is then the total book value divided by the number of shares outstanding.

The price-to-book (P/B) ratio compares a firm's market capitalization to its book value. Often, a company's market price (in the stock market) will greatly exceed its book value. This is because a company's stock is worth more than just the value of its assets. Companies have brand value, human capital (i.e., employees), intellectual property, and other intangibles that are often worth more than the company's physical things.

A low P/B is therefore a signal to value investors that a company's shares may be undervalued since they do not fully account for those other things. However, P/B can be gamed by a company's managers using buybacks.

Let's look at an example that shows how buybacks affect earnings per share and book value per share of a super-sized corporation doing a large one-time buyback.

XYZ Corporation: Pre-Buyback

1. Total assets $300 billion - Total liabilities $150 billion
   Book value = $150 billion
2. Book value $150 billion / Shares outstanding 1 billion
   Book value per share = $150
3. Annual earnings $20 billion / Shares outstanding 1 billion
   Earnings per share = $20
4. EPS $20 / Book value $150 per share
   Return on equity = 13.3%

Assume XYZ's stock is trading at $200 per share and XYZ buys back half of all its shares (500 million in all), or a total of $100 billion of shares. In the real world this would take place over a number of years at various prices, but for illustration purposes let's assume it all happened at once.

XYZ Corporation: Post-Buyback

Note: $100 billion of cash assets was spent to buy 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 post-buyback 500 million
   Book value per share = $100 per share
3. Annual earnings $20 billion / Shares post-buyback 500 million
   Earnings per share = $40 per share
4. EPS $40 per share / Book value $100 per share
   Return on equity = 40%

Notice that when the shares are repurchased above the current book value per share, it lowers the book value per share. If the stock was trading below book value, which is rare, the company could have raised its book value per share through a buyback.

There are several ways a buyback could show up on a corporate balance sheet, depending on several factors, but to keep it simple let's assume XYZ repurchased the shares with cash on hand, and then retired the shares. It's as if they burned the shares, never to be issued again. This results in a decrease in cash assets and therefore a decrease in shareholders' equity on the balance sheet, with no corresponding gain in other assets.

There are other, more complicated ways a company could handle the reporting of the buyback, such as issuing debt and holding the repurchased shares as treasury stock.

How Should You Interpret Buyback Results?

As you can see in this example, there is a major distortion of book value per share due to a major share repurchase done above the current book value per share number.

Buybacks improved the EPS from $20 to $40, but lowered book value per share from $150 to $100. Also, notice that the return on equity (ROE) measurement goes from a rather normal 13.3% to an astounding 40%. ROE numbers can make a normal business look extraordinarily good but should be viewed as an accounting abnormality when a major buyback occurs.

Example of How Buybacks Impact Financials

Dollar Tree (DLTR) is a company that has regularly done share buybacks. Let's examine what these buybacks have done to its financial ratios.

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

Dollar Tree's share count went from 114 million to about 90 million shares through share buybacks, a decrease of 21%. While EPS grew superbly from these buybacks, book value did not fare so well. It only grew $2.35, or 26%, from $8.90 per share to $11.25 per share, while the total EPS that Dollar Tree earned was $7.06.

It's important to remember that each dollar of earnings does not always add to book value, although most of it should, in theory. This assumes no dividends are being paid, which is the case with Dollar Tree. Dollar Tree's earnings were generally used to repurchase shares each year along with normal business expansion costs.

The Bottom Line

If you use the price-to-book ratio as a measure of value, then you need to be careful if a company has been buying back stock. How can you tell if this has happened? Look at the company's total share count over successive years.

The best solution for an investor is to look at growth in EPS and ROE, as well as price-to-book value, in the light of any artificial effects from buybacks.