Why Is Warren Buffett Buying Back Berkshire Hathaway Stock?

Warren Buffett
Warren Buffett

Earlier this month, famed billionaire and Berkshire Hathaway (BRK-A) (BRK-B) chairman Warren Buffett dropped a bombshell.

Breaking with past practice, and changing the financial rules he himself laid down, Berkshire is buying back its own stock -- and plans to keep buying back its stock at any price up to and including 1.2 times "book value."

What's book value?

"Book value" is basically the price of a company's constituent parts before they've been assembled into a whole, tradable corporate stock. Technically, book value is defined as: "The net asset value of a company, calculated by total assets minus intangible assets (patents, goodwill) and liabilities."

But don't let that throw you. You don't have to understand any of this financial gobbledygook to get the gist of this story.

What's important is this: A little over a year ago, in September 2011, Warren Buffett announced that Berkshire would begin buying back its shares at any price up to 110 percent of the company's book value. This was surprising because in years past Buffett had been critical of share buybacks -- and how some companies use them to "pump or support [their] stock price."

Regardless, last September, Buffett said he'd start buying back shares, too. And he'd keep on buying as long as the price was at that level or lower, potentially spending billions of dollars buying back Berkshire stock, because in his opinion the company was "worth considerably more" than its shares were selling for.

Fast-forward to today. Earlier this month, Buffett announced that he would go one step further and buy Berkshire shares at up to 120 percent of (or 1.2 times) their book value.

What does the buyback mean?

There are two ways of looking at Buffett's recent announcement. The first way, the way Buffett would spin it, is that Berkshire Hathaway is buying shares simply because they offer an incredible value at today's prices. And there's truth to that.

After all, if you look back through history, shares of Berkshire Hathaway have traditionally sold for much more than 1.1 times book value, or even 1.2 times book. In fact, over the course of the dozen years of this newest millennium, Berkshire shares have sold for an average of more than 1.5times book value. (And occasionally, for more than twice book value.)

So on the surface, even paying 1.2 times book, Buffett is still buying back his shares at a considerable discount to their usual price -- about 20 percent below average.

What else could it mean?

A more disturbing theory to explain Buffett's decision to spend more on Berkshire stock is this: Doing so is simply choosing the lesser of evils.

Remember, Berkshire's biggest "problem" most years is figuring out what to do with all its money. The company is sitting on $47.8 billion in cash right now. With banks paying 0.1 percent interest, he can't afford just to sit on it, though. He's got to invest it in something.

Elsewhere in the market, we're seeing a wave of mergers and acquisitions as other companies fling bags of cash around, investing their cash in buyouts. In the past few weeks alone, we've seen TJX (TJX) buy Sierra Trading Post for $200 million, and watched Oracle (ORCL) acquire Eloqua for $850 million, while General Electric (GE) took out Avio Aviation for a whopping $4.3 billion. With $48 billion to play with, give or take, Buffett could have done any or all of these deals without batting an eye.

He didn't.

Instead, what did the smartest investor in the world today -- and perhaps the smartest businessman in history -- do? He looked around at a stock market where the average company costs two times book value and muttered to himself "too expensive, too expensive." Then he took a second look at his own stock and said to himself, well, it's not as cheap as it once was, but it's still cheaper than what these other jokers are charging.

And so Buffett upped his spending limit and agreed to buy himself for 1.2 times book, rather than paying nearly twice that for a bunch of lesser businesses.

What does it mean to stock market investors?

No one ever accused Warren Buffett of becoming a billionaire by dumb luck, or by making dumb decisions to overpay for businesses.

The question we need to ask ourselves today is: If Warren Buffett can't find anything worth buying that's cheaper than his own company, and if he is willing to bite the bullet and pay more than he wanted to for his own stock in consequence, what does that mean for us?

Maybe it means we should think twice before putting more money into an overpriced stock market, too.

Motley Fool contributor Rich Smith does not own shares of any company named above. The Motley Fool owns shares of Berkshire Hathaway, General Electric Company, and Oracle. Motley Fool newsletter services recommend Berkshire Hathaway.

Warren Buffett Comments On Stock Purchases On CNBC
Warren Buffett Comments On Stock Purchases On CNBC