Berkshire Annual Letter 1999 (Part 4)
There are a couple of conditions which must exist for a share repurchase scheme to be meaningful to shareholders.
The company must available funds (cash plus sensible borrowing capacity) that more than meets the near term needs of the business. These needs consists of:
- expenditures a company must make to maintain its competitive position and
- optional outlays aimed at business growth.
In cases where funds exceed these needs, it can grow by buying new businesses or by repurchasing shares.
If the market price of the share is selling way below its intrinsic value, calculated conservatively, then it makes sense to buy back its own shares. Sharesholders should have been supplied with all the information they need for calculating that value.
The worst reason for buying back shares is to support the share price. If the price is higher than the intrinsic value, it is akin to buying $1 bills for more than a dollar. This benefits exiting shareholders at the expense of those who stay.
Another silly reason given is that share repurchases are used to offset the shares issued when stock options are exercised (at much lower prices). This “buy high, sell low” strategy does not make any sense.
Just because options have been issued and exercised is no reason to buy back shares. The underlying basis should always consider the relation of market price to intrinsic value.
Warren Buffett will never buy back Berkshire’s shares with the intention of stemming a decline in the price. Rather, he will do so only when Berkshire stock is selling well below intrinsic value, conservatively calculated.
The effects of such a buy-back at low volumes might not be significant. For example, a repurchase of 2% shares at a 25% discount to intrinsic value produces only a 0.5% gain in that value at most.