There are different ways in which the value of a stock can grow. The most typical example is when the value of the whole company increases over time due to growing cash flows and earnings.
Another one, related to share buybacks, is when the company is sliced into fewer pieces – fewer shares outstanding – and each individual share is worth more because it’s entitled to a bigger percentage of the company’s earnings and cash flows.
Creating value through buybacks
According to Warren Buffett, who understands a thing or two about capital allocation, buybacks can be a great thing for investors when the right conditions are in place. From Berkshire Hathaway Inc. (NYSE:BRK-B)‘s 2011 shareholder letter: “Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.”
Following these guidelines, Buffett has designed for Berkshire Hathaway Inc. (NYSE:BRK-B) what is arguably the most efficient and transparent buyback policy around. The company will repurchase shares provided it has more than $20 billion in cash at hand for different uses, and the stock must also be trading at an attractive valuation, which Buffett has defined as a price to book value ratio below 1.2.
Buffett has only been able to repurchase small amounts of stock under Berkshire Hathaway Inc. (NYSE:BRK-B)’s strictly defined policy, but he has provided valuable principles to keep in mind when analyzing other companies and their repurchase programs.
Two businesses are better than one
With more than $703 billion in assets under management and administration, Ameriprise Financial, Inc. (NYSE:AMP) is one of the leading financial services companies in the U.S. Over the last few years the company has expanded its asset management operations via acquisitions like J. & W. Seligman in 2008 and Columbia Management in 2010.
Ameriprise Financial, Inc. (NYSE:AMP) generates nearly equal amounts of income from its insurance and asset management segments nowadays, and this provides a nice combination for the company. While asset management generates high returns and low capital requirements, the insurance business produces recurrent and stable cash flows.
The business is performing strongly; operating net revenues increased 17% and operating earnings grew by 39% in the last quarter. The stock is reasonably valued with a P/E ratio of 16 and a dividend yield of 2.1%, so management is doing the right thing by aggressively repurchasing stock.