Why Share Count Matters
Updated: Sep 24, 2021
One topic I find (most) investors don’t focus on enough relative to its importance is share count. Whether a stock’s outstanding shares will go up, down, or stay the same over the next 10 years can determine whether an investment is a 100 bagger vs. a market underperformer. It baffles me that this topic, at least in the investing circles I frequent (i.e. just Twitter), doesn’t get much attention.
For example, assuming free cash flow or earnings yield stays constant, a stock that 10x’s its profits while simultaneously reducing its share count by 90% is a 100 bagger. Conversely, a stock that 10x’s its profits but also 10x’s its share count has gone nowhere (again, assuming the earnings multiple stays the same).
What makes share count go up? Share issuance. Most of the time this happens through common stock offerings or through stock options and RSUs granted to employees. A rising share count is a headwind to stock performance over the long term, as it hinders free cash flow per share (the only financial metric that matters).
What makes share count go down? Share repurchases, otherwise known as buybacks. These happen at management’s and the board of director’s discretion and help reduce the number of shares outstanding for a stock. Assuming the underlying business stays the same or grows, a reduction in share count is a tailwind to stock performance over the long term since it helps grow free cash flow per share.
Since a lot of companies both give out stock options and buy back stock, I like to think of change in share count as a game of tug of war. On one side is share dilution (options, share offerings) and on the other is share reduction (buybacks). What side is stronger determines where share count is headed over the next decade.
Valuation is Crucial
Okay, so we know reducing share count can be extremely helpful in finding long-term winners in the stock market. But how do we prospectively find businesses that can meaningfully reduce share count? Outside of business quality or growth, I look for two things: a cheap or reasonable valuation, and a management team that has willingly bought back shares in the past.
A cheap valuation is crucial for buybacks to have any effect. For example, if a stock has 100 million shares outstanding but is only able to repurchase 1% of its float each year, after a decade its share count is still above 90 million. This no doubt helps grow free cash flow per share, but investors are getting meager returns from the stock management is buying back. Under the same scenario, but increasing the repurchase to 4% of the float each year, share count goes down to 66.5 million. At 8%, 43.4 million. The only way a company can sustainably buy back large chunks of its shares is if it has a high free cash flow yield. A stock that consistently trades at a P/FCF of 30 or higher is going to struggle to reduce its share count. That’s just the equation we are working with.
To hammer home this point, I thought it would be useful to show some examples of a rising or shrinking share count in action, and how it impacts a company’s financial metrics. I’m going to use revenue per share (rev/share), but this applies to cash flow or any other financial as well.
The king of reducing share count is AutoZone. Since around 2000, management has consistently bought back stock at a reasonable valuation, leading share count to go from 152.7 million down to 21.6 million over the last 20 years. Last year, AutoZone had $12.6 billion in revenue. In 2000, revenue was $4.48 billion. That is a 5.3% CAGR over the last 20 years. But if we look at rev/share, it is a whole different story. In 2000, rev/share was $29.33. Last year, it was $583.33. That is a 16% CAGR, showing the impact a consistent buyback program can have on a stock’s financial performance.
(As a side note, I was just doing some quick math here, so some numbers could be slightly off. But they are directionally correct)
Conversely, let’s take a look at everyone’s favorite automaker, Tesla. Last year, it did $31.5 billion in revenue, and in 2016 it did $7 billion. That leads to a strong CAGR of 45% over that four-year time span. However, in 2016 Tesla’s share count was around 650 million (might slightly change depending on what time of the year you’re looking at), while today it sits at 963.33. So in 2016 rev/share was $10.77 and last year it was around $32.70. This brings the rev/share CAGR to 32%, significantly lower than what overall revenue compounded over that time period.
This also brings up an important point, that share dilution is just a headwind, it doesn’t mean an investment will perform poorly (as we all know, Tesla stock has performed wonderfully in conjunction with a rising share count). And just because a company repurchases stock doesn’t mean it will do well (take a look at the long-term Bed Bath and Beyond chart for an example of this scenario).
To wrap up, let’s talk about two simple leading indicators investors can use to gauge where share count may go for a particular security in the future (for some this may be glaringly obvious, but it is vital for anyone making bets in the stock market). For share dilution, you can look at the number of stock options (or the various equivalent tools like RSUs) a company has that have been granted but not yet exercised. This can be found in the 10-K. And for share reduction, look for any press releases or announcements of share buyback programs, and weigh the dollar authorization vs. the current market cap of the business to evaluate its relevance (a $300 million program on a $3 billion market cap is a lot different than a $300 million program on a $300 billion market cap).
Share count matters. It is something all investors should care about.
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Disclosure: The author is not a financial advisor. Brett Schafer and Ryan Henderson are portfolio managers at Arch Capital. Clients of Arch Capital may hold securities discussed on this post.