Corporate managers are charged with a straightforward task: to enhance shareholder value. Oftentimes, creating value means introducing a new product or taking steps to cut costs and overhead -- complex steps that can take years to implement.

But there's another more direct way to boost value, a method that's been endorsed by none other than legendary billionaire investor Warren Buffett. In his 1984 annual letter to Berkshire Hathaway shareholders, Buffett wrote that companies with outstanding businesses, solid financials and an undervalued stock could perform "no alternative action that could benefit shareholders as much as share repurchases." In other words, Buffett believes that companies with undervalued stock prices can return significant value to shareholders by simply buying back their own stock.

So why are buybacks so value-enhancing? Buybacks are a direct way of returning cash to shareholders, directly boosting each shareholders stake in a firm.

A share of stock represents ownership in a company and a share in the profits that business generates over time. Each share represents an equal stake in profits.

Consider what happens when a company repurchases stock. This action has no effect on the total profits the business generates nor does it enhance competitiveness. However, there is a profound effect on the company's earnings per share (EPS) -- total earnings divided by total shares outstanding. As a firm repurchases its shares, its existing shareholders own a larger and larger slice of the firm's earnings pie, thereby boosting EPS.

For example, consider a firm with $100 million in total earnings and 50 million shares of stock outstanding. That firm's EPS would be $2 per share.

Further, assume that company's earnings remain flat at $100 million per year but the firm buys back 10 million shares of stock. In this case, earnings per share would rise to $2.50 -- the same $100 million in profits is now represented by only 40 million shares of stock. Thus, while total profits remain stagnant, the key EPS figure rises. That means that each existing shareholder now owns a larger slice of the firm's total profits.

Most analysts use the price-to-earnings (P/E) ratio of a firm as a key valuation metric. The higher the P/E ratio, the more richly valued and expensive the firm. Since P/E is calculated by dividing the price of a stock by the EPS, buying back stock also has the effect of lowering the firm's P/E. Lowering this key valuation ratio makes the stock more attractive to investors.

Of course, share repurchase programs do far more than just directly boost shareholders' stake in a firm, they raise the value of the remaining shares...

Important Note: In the remainder of this article, Market Advisor editor Paul Tracy lists seven companies with aggressive buyback programs, some of which have purchased as much as 33% of their own outstanding shares in the past five years. Even better, Paul profiles two companies buying back shares at incredible rates -- and both have compelling stories. However, in order to view the remainder of this article, you'll need to subscribe to our premium investing newsletter -- Market Advisor. After you subscribe, you'll receive immediate access to this full article, as well as our monthly Market Advisor newsletter and a host of additional premium content. Please visit one of the following links to continue.

-- Paul Tracy
Editor
StreetAuthority Market Advisor

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