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Addition By Subtraction
Weekly Newsletter
Addition By Subtraction
If you're a fan of the show, "The Office," like I am, you may remember the episode where Dwight Schrute, Dunder Mifflin's top salesman, leaves the company to go work for Staples. Afterwards, Andy Bernard, Dwight's former co-worker, is sucking up to Michael in hopes of becoming Michael's #2. A spot formerly reserved for Dwight.
Michael, lamenting how Dunder Mifflin lost its top salesman, says, "Yeah, well, it is a big loss. Dwight was the top salesman." Andy responds, "Right, addition by subtraction." A statement implying Dunder Mifflin is better off without Dwight.
The line makes me chuckle, even while writing these words, because it just doesn't make any sense...except in the world of investing. I'm talking about share repurchases.
Share repurchases, also called buybacks, result in a company becoming more profitable per share, even without earning any more money. It's a peculiar thing.
Over the long-term, share price tends to follow earnings per share (EPS). So if EPS increases, share price won't be far behind. The calculation for EPS is as follows:
EPS = Net Income / # of shares outstanding
Share repurchases reduce the denominator in that equation. So, even if Net Income stays the same, EPS can increase if the total number of shares outstanding decreases. Addition by subtraction!
Take the below example for XYZ Inc., who approved a share repurchase program to reduce total number of shares outstanding. Before initiating the program, there were a total of 6 shareholders.
XYZ Inc. approached 3 of its shareholders (D, E, and F) and offered to buy their shares. After some negotiation (aka the stock market), the 3 shareholders sold to XYZ Inc., which allowed the company to retire those shares.
Now there are only 3 shareholders (A, B, and C) of XYZ Inc. And, as represented by size, what happened to the value of their shares even while net income stayed the same? It increased! As did their ownership stake in the company.
A company that buys back its own stock is creating value for shareholders. It's an excellent quality to look for in a company. I show you how to spot it here.
Couple share repurchases with increasing net income and you've got yourself a good recipe!
Williams-Sonoma, Inc.
Williams-Sonoma, Inc (ticker: WSM) is a great example of a company that's shareholder friendly. Not only is WSM increasing actual earnings year after year, but it also pays a dividend and repurchases a lot of stock. The trifecta of investing.
Here are the compounded annual growth rates (CAGR) for WSM for the past 10 years:
- Revenue: 7.9%
- Assets: 7.9%
- Free cash flow: 16.0%
- Earnings per share: 20.4%
A major reason why EPS has grown 2x faster than revenue is because of share repurchases. Don't underestimate its value when done correctly.
These are enviable results by any measure. But as always, I encourage you to do your own homework.
Quote of the day
Tip of the day
Invest in companies that are friendly to shareholders.
You don't want to own stock in a company whose main objective is padding its own pockets. Here are a few things to look for in a company:
- It pays a dividend
- It's repurchasing shares
- Stock-based compensation (SBC) is reasonable and not diluting shareholders
- Total number of shares outstanding is decreasing over time
- It's not quick to issue shares to raise capital, thereby diluting shareholders
Related Articles
Here are a few articles relevant to this week's newsletter. Be sure to give them a read.
- Exceptional Stocks Are A 4-Legged Stool
- How To Analyze The Income Statement (For Beginners)
- Adjusted Earnings And Met's Pitcher Sidd Finch
Welcome to HINDSIGHT UNIVERSITY!
by Caleb McCoy
Enroll in Hindsight U! Where I’m sharing today what I wish to have known a long time ago. How many of us found ourselves learning about investing and personal finance only after entering the workforce? How many of us lament not having the knowledge and foresight to drop our life savings into Apple or Amazon when we were 18 years old? Hindsight is 20-20. But it’s not too late!
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