You own a business

Say you and nine friends start a public company that makes coffee machines. We’ll call it “Espresso Yourself.” You have high hopes for this business as people tend to replace their broken coffee machines regardless of what the economy is doing.

One year, $1 million

Success! In only a year, after settling the business’s expenses – everything from salaries, materials costs, rent and utilities to equipment maintenance bills – there’s $1 million in cash remaining from revenues. This is called “free cash flow.”

Your first dividend

It’s now up to you and your nine partners to decide what to do with this money. Do you divide up the cash? Build another manufacturing plant? You settle on each taking an equal portion of the $1 million. Since you own 10% of the business (because you’re one owner out of 10), you get 10% of $1 million, or $100,000. This is called the “dividend.” Not bad for your first year in operation.

Then there were nine

At the end of year two, Espresso Yourself hasn’t grown, so it generates another $1 million. Unfortunately, one of your partners falls ill and wants out of the business, which gets appraised at $10 million. His share is worth $1 million. You decide to use the free cash flow to buy him out, called a “share buyback.” Conveniently, the $1 million in free cash flow is equal to the value of his share. You now own 1/9th of the business.

Your dividend grows!

The third year passes and the company again generates $1 million. Everyone decides to take another dividend. This time, your dividend climbs from $100,000 to $111,111 because only nine partners are getting a slice of the pie.

Neither the coffee machine market nor Espresso Yourself is growing. But the business isn’t shrinking either and continues to generate $1 million in free cash flow every year.

More partners leave

The following year, another partner leaves the business. Luckily for you, this partner isn’t smart enough to realize that his stake has increased in value (in other words, the company’s share price hasn’t increased) and is willing to sell his stake for $1 million. Again, you and your remaining partners use the $1 million in free cash flow to buy him out. This happens a few more times until you’re one of five business partners.

$200,000 dividend!

You’re starting to feel a little lonely but you’re otherwise happy because your share of the company’s earnings keeps getting bigger. Now that the $1 million is being split five ways, your dividend is $200,000, double what you got the first year. This from a company that isn’t even growing.

A bright future

You start to think about the value of your share. Does it make sense that you’re earning twice as much as you did in your first year of operation?

Surely your investment is worth more. But the business hasn’t grown – it’s still worth $10 million. Except there are now five partners left from the original 10. It doesn’t take a mathematician to figure out that $10 million divided by five is $2 million. What were your buddies thinking? Not only are you earning twice as much in the fifth year as you did in the first, your investment has doubled in value.

Imagine how much wealthier you’d be if another partner, not realizing the value of these share buybacks, also sold his stake for $1 million. Better still, consider the numbers if this business was growing!

Mental gymnastics

Some of your competitors go out of business. You and your remaining partners decide to sit down for your first official forecasting dinner. While being fairly conservative about the company’s future prospects, you believe your sales could increase significantly for at least the next few years.

Does this mean that if your cash flow increases by 10% after the first share buyback (and by 11.1% and 12.5% after the second and third buybacks…you get the idea) you can anticipate an even greater return if your company grows?

Sounds too good to be true. Yet these are exactly the kinds of opportunities seasoned investors find daily. Companies can use their free cash flow to buy back their own shares. Although this doesn’t always immediately translate into a higher share price, eventually the market recognizes the value accrued for remaining shareholders.

In financial speak, if the free cash flow multiple – the price you’re willing to pay for a dollar of earnings – stays the same, the stock price has to go up. The math is just that simple.