McKinsey & Company
How share repurchases boost earnings without
Ezekoye, Tim Koller, and Ankit Mittal
Some actions that boost earnings per
share don’t create value for shareholders. Share repurchases are
generally a wash.
Of all the measures
of a company’s performance, its earnings per share (EPS) may be the
most visible. It’s quite literally the “bottom line” on a company’s
income statement. It’s the number that business journalists focus on
more often than any other, and it’s usually the first or second item
in any company press release about quarterly or annual performance.
It’s also often a key factor in executive compensation.
But for all the attention EPS receives,
it is highly overrated as a barometer of value creation. In fact, over
the past ten years, 36 percent of large companies with
higher-than-average EPS under-performed on average total return to
shareholders (TRS). And while it’s true that EPS growth and
shareholder returns are strongly correlated, executives and naïve
investors sometimes take that relationship too seriously. If improving
EPS is good, they assume, then companies should increase it by any
The fallacy is believing that anything
that improves EPS will have the same effect on value creation and TRS.
On the contrary, the factors that most influence EPS—revenue growth,
margin improvement, and share repurchases—actually affect value
creation differently. Revenue growth, for example, can increase TRS as
long as the organic investments or acquisitions behind it earn more
than their cost of capital. Margin improvements, by cutting costs, for
instance, can increase TRS as long as they don’t impede future growth
by cutting essential investments in research and development or
For example, to improve EPS, managers at
one company committed to an aggressive share-buyback program after
several years of disappointing growth in net income. Five years later,
managers had retired about a fifth of the company’s outstanding
shares, increasing its EPS by more than 8 percent. Yet the company was
merely retiring shares faster than net income was falling. Investors
could see that the company’s underlying performance hadn’t changed,
and the company’s share price dropped by 40 percent relative to the
Share repurchases seldom have any
lasting effect on TRS—and that often comes as a surprise to managers
and investors alike. Given how often we hear executives advocate share
repurchases because of their effect on EPS—and make the occasional
argument for taking on debt to execute them—it is worth exploring the
relationship between buybacks, EPS, and shareholder returns. We’ll
begin by examining the empirical evidence and then look at the logic
behind so many decisions to repurchase shares.
Companies that repurchase shares when
prices are low can create value for those shareholders who don’t sell
if the share price rises as a result. As our prior research has found,
however, most companies don’t time these purchases well.
Rather, we find that many executives
have come to believe that share repurchases create value just by
increasing EPS. The logic seems to be that earnings across a smaller
number of shares mathematically increases EPS, and if EPS increases
and the price-to-earnings (P/E) ratio stays constant, then a company’s
share price must increase.
The empirical evidence disproves this.
For while there appears to be a correlation between TRS and EPS
growth, little of that is due to share repurchases. Much of it can be
attributed to revenue and total earnings growth—and especially to
return on invested capital (ROIC), which determines how much cash flow
a company generates for a given dollar of income. All else being
equal, a company with higher ROIC will generate more cash flow than a
similar company with lower ROIC. But without the contribution of
growth and ROIC to TRS, there is no relationship between TRS and the
intensity of a company’s share repurchases (Exhibit 1).
That’s because it’s the generation of
cash flow that creates value, regardless of how that cash is
distributed to shareholders. So share repurchases are just a
reflection of how much cash flow a company generates. The greater the
cash flow, the more of it a company will eventually need to return to
shareholders as dividends and share repurchases.
The error in valuing repurchases in isolation
The idea that share repurchases create
value by increasing EPS also errs in its failure to consider other
possible uses of the cash, such as paying dividends, repaying debt,
increasing cash balances, or investing in new growth opportunities.
What matters is the effect of a share repurchase relative to those
other actions, not the effect of the repurchase on its own.
Repurchase versus dividend
Consider the effect of a hypothetical
company using cash to repurchase shares relative to using it to pay an
equivalent dividend. The company earns $100, has a P/E ratio of 15,
and makes no investments, so managers can distribute the earnings as
dividends or as share repurchases (Exhibit 2).
If the company pays out its earnings as
dividends, its value will be $1,500. Shareholders will also have
received $100, so the total value to the share-holders is $1,600. On a
per-share basis, the share price will be $15. Since each share will
also have received $1 in dividends, the total value and cash per share
will be $16.
If the company pays out its earnings by
repurchasing shares, its total value will remain the same, $1,500, and
shareholders as a whole will have received the same amount of cash,
$100. On a per-share basis, for those shareholders who don’t sell,
each remaining share will increase in value to $16 because the
earnings are now divided by a smaller number of shares. For an
individual share, this is economically equivalent to having a share
worth $15 plus cash of $1 from a dividend.
The mechanical effect on EPS is
irrelevant. If the company pays a dividend, shareholders retain their
shares and receive cash. If the company repurchases shares, the
selling shareholders receive cash and the remaining shareholders have
shares with higher value (but they don’t receive any cash). Overall,
there is no change in value, just a change in the mix of shareholders.
Repurchase versus debt reduction
Comparing the effect of using cash to
repurchase shares with using it to pay down debt is more complex. The
reason is that when the company pays down debt, its capital structure,
cost of capital, and P/E ratio change. Yet because the enterprise
value of the company stays the same, so does the value to
In this comparison, suppose our
hypothetical company has $200 of debt in the base year (Exhibit 3). In
that base year, the company’s enterprise value is $1,500 and its
equity value is $1,300. Note that the enterprise value divided by
after-tax operating profits is now different from the P/E ratio, at
15.0 and 13.8 times, respectively. The P/E ratio is lower because the
higher leverage increases the riskiness of the equity, leading to a
higher cost of equity.
If the company repurchases shares, the
enterprise value and equity remain the same as in the base year. In
addition, shareholders receive $100 in share repurchases, so
collectively, the shareholders will have $1,300 in equity value plus
$100 of cash, for a total of $1,400. The remaining shares outstanding
will be worth $14 per share.
If the company pays down debt instead,
the enterprise value remains the same, but the equity value increases
by $100. Note that the enterprise value doesn’t change because the
operating cash flows of the company have not changed. However, the
value of the equity increases by the amount of cash retained and used
to pay down debt. The value of the company to all the shareholders is
the same as the sum of equity value and cash distributed in the share
repurchase, or $1,400.
The equity value of $1,400 divided by a
net income of $97 produces a P/E ratio of 14.4. Note that the P/E
ratio in the base year, as well as in the share-repurchase scenario,
was lower, at 13.8. The increase in the P/E ratio is due to the
declining leverage, leading to less risky equity and a lower cost of
On a per-share basis, repurchasing
shares increases EPS, in this case from $0.94 to $1.01, but the
increase in EPS is offset by the lower P/E ratio relative to the
scenario of paying down debt. On the off chance that a company might
borrow cash to repurchase shares, for example, it would increase a
company’s EPS because the effect of reducing the share count is larger
than the reduction in net income due to additional interest expense.
However, with its increased debt, the company’s equity would be
riskier and, all else being equal, its P/E ratio would
decline—offsetting the increase in EPS.
Repurchase versus investing
Finally, consider what happens when,
instead of repurchasing shares, our hypothetical company invests that
same amount of cash, $100, back in the business. Assuming it earns a
return of 15 percent, which exceeds its cost of capital, its income
would increase by $15 (Exhibit 4).
Assuming the enterprise-value multiple
remains constant at 15 times, the enterprise value and equity value
will increase to $1,725—which is more than the sum of the equity value
and the cash paid out in the share-repurchase case. The EPS is also
higher in the investment case.
Investing at an attractive return on
capital will always create more value than repurchasing shares, but it
doesn’t always do so as quickly. In this simple example, we’ve assumed
that the company earned an immediate 15 percent return on its
investment. That’s often not realistic, since there will be a lag
between when a company invests and when it realizes a return. For
example, if the company didn’t earn a return until year three, its EPS
for the first two years would be higher from share repurchases than it
would be from investing. This explains the temptation to repurchase
shares instead of investing. With a share repurchase, the effect on
EPS is immediate, and with investing, it is delayed. Disciplined
managers won’t fall for the short-term benefit at the expense of
long-term value creation.
Improving a company’s earnings per share
can improve its return to shareholders. But the contribution of share
repurchases is virtually nil.
About the author(s)
is an associate principal in McKinsey’s Minneapolis office, Tim
Koller is a principal in the New York office, and Ankit Mittal
is an analyst in the Delhi office.
 Bin Jiang and Tim Koller, “The
savvy executive’s guide to buying back shares,” October
 Based on a multivariate regression,
there was no statistical relationship between total return to
shareholders and share-repurchase intensity after taking into
consideration growth in economic profit. Growth in economic profit
incorporates both total earnings growth and return on invested
We’ve eliminated debt to simplify this example.
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