Dividends and share buybacks are capital allocation decisions by management. While you’d think that most shareholders would like to receive more in dividends or see their company buy back more shares, there are trade-offs.

A bigger dividend, for example, might suggest that management sees fewer good investment opportunities within the business. And if share buybacks are done at prices above the company’s intrinsic value, then value is being destroyed not created.

In saying that, buybacks carried out at sensible prices for a long period of time can turbo-boost shareholder returns. An example you’ll often see used here is Autozone, which has seen its share price rise by 5x since 2014 while annual operating earnings have risen by “just” 90%.

The reason? Autozone (NYS:AZO) has used the bulk of its free cash flow to reduce its share count from 34 million shares in 2014 to 19 million in 2024.

An owner of one million Autozone shares in 2014 owned just under 3% of a company with $1.8 billion in annual operating earnings. Assuming this investor sold no shares, they now own 5.2% of a company that generated $3.5 billion in operating earnings last year.

This imaginary investor's ownership stake – which has increased without them buying a single share more – is clearly more valuable today than it was in 2014.

Autozone has worked out very well for those who bought and held on. But does that mean that any huge share buyback scheme is manna from heaven? Sadly not. Buybacks can’t escape Warren Buffett’s “golden rule of capital allocation”: the fact that “what is smart at one price is dumb at another”.

This means that you only want management to repurchase shares when they are trading at a discount to intrinsic value. You also want to make sure that buybacks aren’t being funded to the detriment of the company’s long-term health.

This could arise if the buybacks were being funded by taking out an unsustainable amount of debt, or by forgoing important investments in the company’s business offerings and moat.

Two cheap companies that have bought back shares

With all of that in mind, I thought I’d look for moated companies that are trading below our analysts’ estimate of Fair Value and have been buying back shares. To capture this, I initially searched for companies with:

  • A Wide or Narrow Moat rating
  • A four or five star Morningstar rating
  • A Capital Allocation rating of standard or better
  • A current share buyback yield of over 5%

Before we go any further, a quick note on buyback yields. This number is calculated by dividing the amount of share buybacks made in dollars, pounds etc. by today’s market capitalisation. I realised that this metric has the potential to mislead you in two ways.

One, it is backwards looking. The company might not continue buying back shares in the future. Two, if a company’s shares (and therefore market cap) have fallen heavily, the “current” buyback yield rises. This can imply that the company has bought back a lot more of its shares than it actually did.

Take Burberry (LON: BRBY) for example, which currently shows a buyback yield of 19%. This represents the 400 million in buybacks it made during its latest full year, divided by its current market cap of around GBP 2 billion. This does not mean that Burberry bought back 19% of its shares last year.

This number is so high because Burberry’s shares have fallen by some 70% over the past year. If you look instead at the change in shares outstanding, you’ll see that Burberry’s share count fell from 386 million shares in 2023 to 365 million shares at the end of fiscal 2024.

A 4.5% reduction is still quite big for a single year, but it isn’t 19%. For you to get a 19% buyback yield going forward, Burberry would need to spend the same GBP 400m on buybacks last year at today’s share prices.

To account for this, I tweaked the criteria in my search to find companies that have actually reduced their share count by more than 5% in the past year. Here are two companies that passed the test.

Adient (NYS: ADNT)

  • Moat rating: Narrow
  • Price to Fair Value estimate: 0.30
  • TTM reduction in shares outstanding: 6.7%

Adient builds seats for automotives, a market in which it has a leading share of around 33% globally. Our analyst David Whiston thinks that Adient has been overlooked by investors for two main reasons: 1) auto parts firms are deeply out of favour and 2) investors mistakenly think that Adient provides a commodity product.

On the contrary, Whiston stresses that success in the seating business requires patents, decades of trust built up with customers, and an ability to play their part in worldwide just-in-time manufacturing regimes. As Whiston puts it in his research report on Adient, “this is not something that just anyone who gets a loan to start a new seating company could do easily or quickly”.

Automakers do not select seating suppliers on price alone. In addition to innovation and product quality, they are looking for reliable partners with a proven ability to service them globally. Whiston says that only Lear compete with Adient at a truly global level, which means the auto industry’s shift to more global manufacturing platforms is a positive for these two firms.

Whiston also notes that it is rare for a seating manufacturer to lose the business for a given model (and even future generations of the same model) once it is won. By contrast, the manufacturer will usually start working on designs for the new generation of vehicle years before it even goes into production. This puts the existing supplier in a great position to keep the business.

Whiston’s seemingly variant view on the quality of Adient’s business is reflected in his Fair Value estimate of $68 per share. As we’ll see shortly, this is far above where the stock currently trades. Whiston’s valuation bakes in average revenue growth of 1.3% over the next five years but it is mostly driven by a big improvement in operating margins over that time from cost-cutting and more efficient manufacturing.

At a current price of around $20.50 per share, Whiston thinks that Adient is materially undervalued and that the company’s big share buyback program is likely a sound use of capital. Adient announced an indefinite $600m buyback program in November 2022 and has stepped up the pace of those repurchases in recent years amid poor share price performance.

Buybacks in fiscal 2023 totaled $65 million and Whiston estimates that buybacks in fiscal 2024 will total USD 300m. In the past twelve months, the company has reduced its share count by around 6.7%. And as of June this year, the initial buyback authorisation still had around USD 300m remaining.

PayPal Holdings (NAS: PYPL)

  • Moat rating: Narrow
  • Price to Fair Value estimate: 0.68
  • TTM reduction in shares outstanding: 6.1%

PayPal has provided a trusted way to pay online for years, most famously - in the early years at least - for customers of its old parent company, eBay. PayPal also owns enterprise payments firm Braintree, small business payments business Zettle and the Venmo cash transfer app, among businesses.

Our analyst Brett Horn has awarded PayPal a Narrow Moat rating, stemming from its position as a clear leader in the e-commerce payment processing niche.

Horn says that PayPal’s two-sided business model (where both the seller and business are PayPal users) gives it data from both sides of each transaction, helping the company combat online fraud and build trust with users.

This was especially important in the early days of e-commerce, however, PayPal’s trusted brand and large user base (which increases the ease of using it to pay) still deliver a material boost to seller conversion rates today. This makes it a preferred partner for e-commerce businesses.

Horn thinks that PayPal shares are worth $104 per share, a price that encapsulates his view that PayPal can grow its revenues by an average of 8% over the next 10 years and that operating margins can rise modestly to 18% from 2023’s 17%. He attaches an Uncertainty rating of High to this valuation, given the fast-evolving online payments space and PayPal’s potential exposure to weakness in the economy.

PayPal shares have performed poorly over the last couple of years. The pandemic pulled forward a lot of revenue growth that could not be sustained. Apple’s continued focus on Apple Pay has also led to concerns that PayPal may find itself being cut out of more transactions.

Here is how much of PayPal’s free cash flow has been spent on buybacks in the past five full years, and how the company’s share price has compared to our Fair Value estimates on average during that year. A Price to Fair Value ratio of over 1 suggests a stock is overvalued versus our estimates. A ratio under 1 suggests that it is undervalued.

paypal-buybacks-by-year

Figure 1: PayPal buybacks versus Fair Value by year. Source: Morningstar/Author

While a lot of buybacks appear to have been done at high valuations in 2020 and 2021, it looks like PayPal have tried to exploit its recent share price weakness by spending much more on share repurchases at lower valuations in 2022 and 2023.

You’ll also notice that PayPal’s number of diluted shares outstanding only actually started to decrease from 2022 onwards. In previous years, share buybacks had merely been keeping pace with the number of new shares that could be created through the vesting of things like employee stock options.

PayPal’s guidance at the end of July suggested that repurchases in their 2024 reporting year will total $6 billion. At a recent price of $71 per share, PayPal traded at over a 30% discount to Horn’s Fair Value estimate. As a PayPal shareholder, the company’s increased focus on buybacks make sense to me.

Disclosure: I have owned PayPal Holdings shares since June 2024.Also please remember that individual shares should only be considered once you have a broader strategy in place. Follow this guide to define your investing strategy.

Comments? Questions? Something else you'd like me to write about? Please feel free to email me at [email protected].

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Terms used in this article

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.