And the winning numbers are…

A few years ago, a California man came forward to claim the $320 million Mega Millions lottery jackpot. But ultimately, the guy walked away with just $29 million (before taxes).

You see, he had pitched in a couple of bucks that morning to form an office pool with 10 coworkers — and thus had to split the lump sum 11 ways.

That’s still a hefty prize. But the winners (who worked for Wells Fargo) were probably happy that their local branch was small. The more pool members to share the cash, the less everyone gets. Even a single extra person (maybe a temp answering the phones that day) would have reduced the winnings by more than $2 million apiece.

It’s not a complicated concept. Investors deal with it almost daily. But instead of sharing the spoils with a dozen co-workers, we must divvy up cash windfalls with hundreds of millions (or even billions) of strangers.

One for You, One for Me, One for Her…

Take Pfizer (NYSE: PFE). The pharmaceutical giant disbursed $9.2 billion in dividends last year. That’s a massive chunk of change — about 30 times the size of that lottery jackpot. But then again, there are nearly 6 billion outstanding shares in circulation. A huge pie cut into tiny slivers.

On a per-share basis, everyone received a check for just $1.64.

It wasn’t always like this. When Pfizer made its market debut in 1942, just 240,000 shares were offered to the public. Imagine if no new shares had been issued since then. This latest dividend distribution would have yielded a cash payment of $38,333 per share.

Of course, growing businesses need fresh capital to expand, and much of it typically comes from equity. Without printing new shares along the way, the drugmaker wouldn’t be where it is today: a global empire pocketing $60 billion in annual sales.

But you get the point. Every additional new share is dilutive, watering down existing stockholders’ proportional ownership claim on earnings and assets.

Except, it’s never just one more share — more like 10 million here, 20 million there. If a billion-dollar company is divided into a billion shares, they are naturally worth $1 apiece. But if the pie is carved into, say, another 50 million slices… Well, you can do the math.

That’s a lot more thirsty mouths crowding around the same water trough… which explains the market’s often hostile reaction to such news.

Last month, AMC Networks (NSDQ: AMCX) shed more than 30% within minutes of announcing plans for a $125 million private convertible note offering.

Fortunately, the reverse is also true.

The market usually cheers a shrinking share count. Who wouldn’t want to see their slice of the pie enlarged — and thus more valuable?

This simple math explains why corporate CFOs (who are paid well to make smart financial decisions with excess company cash) are nearly united in agreement that stock buybacks are an effective lever to pull.

Multiplying 15% Growth Into 27.5%

For the sake of illustration, let’s plug in a few numbers.

Suppose a manufacturer with 1 million shares outstanding produces $2 million in yearly net income. Simple division gives us earnings of $2 per share.

The average price-to-earnings (P/)E ratio among S&P 500 firms is currently running near 27 (meaning investors are paying $27 per dollar of profits). So you might reasonably expect this stock to trade near $54.

But what if management authorizes the repurchase of 100,000 shares, reducing the total to 900,000?

In that event, the same $2 million profit would stretch further and boost earnings per share to $2.22 ($2M/0.9M). That’s a double-digit improvement, even though net income didn’t budge in absolute terms.

Larger slices.

Applying the same earnings multiple, the stock could recalibrate from $54 to nearly $60 ($2.22 x 27).

You’ll notice the underlying market capitalization of the business hasn’t changed. It was $54 million to start ($54 x 1 million shares) and remains $54 million after the buybacks ($60 x 900,000). But with 10% fewer shares, each individual stake in this $54 million asset is worth more.

And that’s with zero change in profitability.

Ideally, the bottom line is growing at the same time that the share count is shrinking. That’s when the magic really happens.

Let’s say the manufacturer raises net income from $2 million to $2.3 million. That’s a decent 15% uptick.

But with 100,000 fewer shares, earnings would surge by 27.5% (from $2.00 to $2.55) — magnifying the financial improvement.

And if the market is still paying 27 times earnings, the stock would now be approaching $70.

Of course, this is a simple mathematical exercise. There are many other considerations in the real world (such as the recent 1% excise tax on buyback expenditures). Still, you can see why boardrooms are so enthusiastic.

ExxonMobil (NYSE: XOM) plans to spend $20 billion in buybacks this year and the same again in 2025. Facebook parent Meta Platforms (NSDQ: META) just approved a massive $50 billion stock buyback program, enough to retire about 5% of the stock at current prices.

That might not sound like much. But consider this: Suppose you own 1% of a profitable business that repurchases 5% of its outstanding shares annually. After five years, your ownership stake in the business would have increased by 30% — without having put another dime in the stock.

That can translate into a 30% gain, even if the underlying value of the business is static.

Studies conducted by Bloomberg and others have provided some illuminating data on this subject. Between 1982 and 2011, the top 25% of stocks in the S&P 500 ranked by buyback yield (net buyback expenditures as a percent of market cap) produced annualized gains of 13.2%, versus 11.0% for the S&P 500.

On a $100,000 portfolio, that excess return would put an additional $50,000-plus in your pocket over a 10-year period.

And the outperformance can be even more exaggerated in environments like this when the economy is tepid and earnings growth stalls.

Now, my standard disclaimer still applies: When companies overpay and repurchase stock for more than its intrinsic value, shareholder value is destroyed, not created. But if done for the right reasons at the right price, then I fully agree with Warren Buffett, who deems stock buybacks “by far the most attractive option for capital utilization.”

That explains why 429 members of the S&P 500 engaged in stock buyback activity last year. That’s about an 85% participation rate.

In aggregate, these companies invested $795 billion in share repurchases. Goldman Sachs expects that total to rise to $925 billion this year — and then pierce the $1 trillion level next year.

For context, that’s greater than the GDP of Switzerland.

Financial Sleight-of-Hand

We’ve covered some of this before. But for the benefit of new readers, it never hurts to revisit this important topic.

More importantly, though, I want to reinforce a key part of this equation that often goes overlooked.

There are countless financial media outlets that monitor the mountains of cash being set aside for corporate stock buybacks. You’ll also find plenty of bullish articles explaining why share repurchases can be more tax-efficient than dividend distributions.

But here’s what they neglect to mention.

Many of the biggest practitioners aren’t making a dent. Rather than slimming down, they are still gaining weight in the share-count column.

During the fourth quarter of last year, S&P buyback dollars increased by 18% to $219 billion. Yet of the 440 companies involved, only 295 saw an actual reduction in share counts — 145 reported an increase.

That’s what happens when you retire four shares with one hand and print five new ones with the other.

This is particularly common in the tech sector, where stock options are a favored form of employee compensation.

Repurchases are simply meant to offset the dilution. If a company spends $90 million on gross buybacks and issues $100 million in new shares, then the net repurchase is actually a negative $10 million.

And net — not gross — is what matters.

Let’s circle back for just a moment to Pfizer. Back in 2022, the company invested $2 billion in buybacks, which repurchased 39 million shares at an average price of $51 per share. Considering the stock has since fallen to $29, that doesn’t appear to have been money well spent.

But here’s the bigger issue.

The share count decreased by just 26 million shares, ending the year at 5,743 million. Why not the full 39 million? Because the buybacks were partially offset by 13 million new shares issued for employee compensation.

I don’t mean to pick on Pfizer — this is actually common practice. But it’s hard to get anywhere with one foot on the gas and the other on the brake.

And while buyback authorizations are trumpeted in the headlines, new share issuance is done quietly and buried in the cash flow statements (a line entry for “proceeds from the sale of common stock”).

But for those who’d rather not dig through SEC filings, it’s fairly easy to keep tabs on the fully diluted share count. And doing so can be well worth the effort.

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