Warren Buffett: The Only Time Share Buybacks Make Sense

There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively calculated.-- Warren Buffett, 2000

Investors love share buybacks. When a company buys shares of its own stock and retires them, it leaves fewer shares outstanding. This boosts earnings per share, because the company's net income is spread over fewer shares. Additionally, the buyback program tilts the supply demand balance for the stock in favor of sellers, which can push the share price higher.

Netflix didn't follow Warren Buffett's buyback rules in 2011.

That clearly violates Warren Buffett's second rule for stock buybacks. According to Buffett, Netflix executives should have made some effort to ensure that they weren't overpaying. Alternatively, Netflix could have returned cash to shareholders through dividends.

As it turned out, Netflix's management team also did a poor job of calculating its excess cash. In the first three quarters of 2011, Netflix spent approximately $200 million to repurchase 900,000 shares of stock. However, Netflix's subscription price increase that summer caused a customer backlash, while the company's international expansion turned out to be very costly.

With more obligations looming and an uncertain path to profit recovery, Netflix decided to raise money that fall. It sold 2.86 million shares at $70/share, for a total of $200 million. Between the buyback in the first three quarters of 2011 and the share sale in Q4, Netflix essentially gave away 2 million shares (worth over $800 million at today's market price).

Netflix also issued $200 million of convertible debt in late 2011. This eventually converted to another 2.3 million shares (worth about $1 billion today: a gain of nearly $800 million for the holder). By spending freely on share buybacks when it should have been bolstering its balance sheet, Netflix was forced to raise capital on extremely bad terms, costing shareholders more than $1 billion.

Foolish final thoughts

Properly executed buybacks can create plenty of value for shareholders. A company that repurchases its stock for less than its intrinsic value makes all of the remaining shares more valuable. However, a poorly executed buyback can just as easily destroy shareholder value: a lesson that Netflix's management learned the hard way.

For other management teams trying to decide whether to buy back shares, Buffett has some simple rules to follow. First, don't spend beyond your means -- make sure you have more than enough cash and borrowing ability to run the business properly. Second, don't buy back shares unless they are clearly undervalued.

Investors should thus be cautious when a company announces big buyback plans. If it seems like the company has thoughtfully evaluated its cash needs and the stock's intrinsic value, it may be good news. If not, then the chances of a good outcome are much lower.

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The article Warren Buffett: The Only Time Share Buybacks Make Sense originally appeared on

Adam Levine-Weinberg is short shares of Netflix. The Motley Fool recommends Berkshire Hathaway and Netflix. The Motley Fool owns shares of Berkshire Hathaway and Netflix. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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