Stock buybacks: A good thing or not?

Flush with cash, Apple Inc. (AAPL) has been repurchasing shares of its stock as a means of trying to boost the share price and provide shareholder value. This may also be seen as a sign by some that the tech giant views the potential return on its own stock as a better investment for its money than reinvesting back into the business.

It's hard to argue with Apple's strategy. Shares of the tech giant gained more than 46% last year as it continues to sell iPhones at scale. For the quarter ending Sept. 30, 2017, Apple recorded earnings per share (EPS) of $2.07 on revenue of $52.6 billion. However, Apple certainly isn't the norm on Wall Street, and analysts continue to ask the question: Are corporate stock buybacks a good thing? (For more, see "Are Share Buybacks Propping up the Market?")

For corporations with extra cash, there are essentially four choices as to what to do: The firm can make capital expenditures or invest in other ways into their existing business; they can pay cash dividends to the shareholders; they can acquire another company or business unit; or they can use the money to repurchase their own shares—a stock buyback.

Similar to a dividend, a stock buyback is a way to return capital to shareholders. While a dividend is effectively a cash bonus amounting to a percentage of a shareholder's total stock value, however, a stock buyback requires the shareholder to surrender stock to the company to receive cash. Those shares are then pulled out of circulation and taken off the market.

Prior to 1980, buybacks weren't all that common. More recently, they have become far more frequent: Between 2003 and 2012, the 449 publicly listed companies on the S&P 500 allocated $2.4 trillion—some 54% of their earnings—to buybacks, according to a Harvard Business Review report. And it's not just giants like Apple and Amazon.com Inc. (AMZN); even smaller companies are getting into the buyback game. For example, SolarWinds Inc. (SWI) in 2015 agreed to buy back almost 10% of its shares—just six years after its initial public offering.

In 2015, stock buybacks by U.S. companies totaled $572.2 billion – the largest sum since 2007. Activity has dipped a bit since (to $536.4 billion in 2016), but overall, companies have plunged nearly $4 trillion of their cash into buying back their stock in the last decade.

According to recent Bloomberg research, more than half of corporate profits (56%) in the U.S. go toward share buybacks. Some economists and investors argue that using excess cash to buy up their stock in the open market is the opposite of what companies should be doing, which is reinvesting to facilitate growth (as well as job creation and capacity).

The biggest social concern about this has to do with opportunity costs: Money that goes to shareholders in a stock buyback program could have been used for maintenance and upkeep. On average, fixed assets and consumer durable goods in the United States are now older than they’ve been at any point since the Eisenhower era (the 1950s). There is a lot of attention paid to the nation's crumbling roads and bridges, but private infrastructure is also suffering neglect – it's just not talked about. (For more, see "What Is Opportunity Cost and Why Does It Matter?")

The scale and frequency of buybacks have become so significant that even shareholders, who presumably benefit from such corporate largesse, are not without worry. “It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies,” wrote Laurence Fink, chairman and CEO of BlackRock Inc. “Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.”

Here's a simple truth (according to the Harvard Business Review report): In 2012, the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. So C-suite executives have little incentive to scale back on buybacks, given the large positions in company stock they typically hold and therefore amount they have to gain. By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly EPS targets.

All that said, buybacks can be done for perfectly legitimate and constructive reasons.

The theory behind share buybacks is that they reduce the number of shares available in the market and – all things being equal – thus increase EPS on the remaining shares, benefiting shareholders. For companies flush with cash, the prospect of bumping up EPS can be tempting, especially in an environment where the average yield on corporate cash investments is barely more than 1%.

In addition, companies that buy back their own shares often believe:

• The stock is undervalued and a good buy at the current market price. Billionaire investor Warren Buffett utilizes stock buybacks when he feels that shares of his own company, Berkshire Hathaway Inc. (BRK-A), are trading at too low a level. However, the annual report emphasizes that "Berkshire's directors will only authorize repurchases at a price they believe to be well below intrinsic value."
• A  buyback will create a level of support for the stock, especially during a recessionary period or during a market correction.
• A buyback will increase share prices. Stocks trade in part based upon supply and demand, and a reduction in the number of outstanding shares often precipitates a price increase. Therefore, a company can bring about an increase in its stock valuation by creating a supply shock via a share repurchase.

Buybacks can also be a way for a company to protect itself from a hostile takeover, or signal that the company plans on going private.

For years, it was thought that stock buybacks were an entirely positive thing for shareholders. However, there are some downsides to buybacks as well. One of the most important metrics for judging a company's financial position is its EPS ratio. EPS divides a company's total earnings by the number of outstanding a shares; a higher number indicates a stronger financial position. By repurchasing its own stock, a company decreases the number of outstanding shares. Therefore, a stock buyback enables a company to increase this important ratio without actually increasing its earnings or doing anything to support the idea that it is becoming financially stronger.

As an illustration, consider a company with yearly earnings of $10 million and 500,000 outstanding shares. This company's EPS, then, is $20. If it repurchases 100,000 of its outstanding shares, its EPS immediately increases to $25, even though its earnings have not budged. Investors who use EPS to gauge financial position may view this company as stronger than a similar firm with an EPS of $20, when in reality the use of the buyback tactic accounts for the $5 difference.

Other reasons buybacks are controversial:

• The impact on earnings per share can give an artificial lift to the stock and mask financial problems that would be revealed by a closer look at the company’s ratios.
• Companies will use buybacks as a way to allow executives to take advantage of stock option programs while not diluting EPS.
• Buybacks can create a short-term bump in the stock price that some say allows insiders to profit, while suckering other investors. This price increase may look good at first, but the positive effect is usually ephemeral, with equilibrium regaining when the market realizes that the company has done nothing to increase its actual value. Those who buy in after the bump can then lose money.

Some companies buyback shares to raise capital for reinvestment. This is all good and well until the money isn't injected back into the company. In July 2017, the Institute for New Economic Thinking published a paper titled "US Pharma’s Financialized Business Model" on pharmaceutical companies and their share buyback and dividend strategy. The study found that share buybacks weren't being used in ways to grow the company, and in many cases total share buybacks outnumbered funds spent on research and development. "In the name of 'maximizing shareholder value' (MSV), pharmaceutical companies allocate the profits generated from high drug prices to massive repurchases, or buybacks, of their own corporate stock for the sole purpose of giving manipulative boosts to their stock prices," the report said. "Incentivizing these buybacks is stock-based compensation that rewards senior executives for stock-price performance." 

And, as mentioned above, any boost to share price from the buyback seems to be short-lived. Along with Apple, Exxon Mobil and IBM have made significant share repurchases. A CNBC article in May 2017 said since the turn of the century, total outstanding shares of Exxon Mobil have fallen 40%, and IBM's has decreased by a whopping 60% from its peak in 1995. The article notes that not only does this fit "financial engineering," but it also affects overall stock indexes that are valued on the weightings in these companies. 

As mentioned earlier, buybacks and dividends can be ways to distribute excess cash and compensate shareholders. Given a choice, most investors will choose a dividend over higher-value stock; many rely on the regular payouts that dividends provide. And for that very reason, companies can be wary of establishing a dividend program. Once shareholders get used to the payouts, it is difficult to discontinue or reduce them – even when that's probably the best thing to do. That said, the majority of profitable companies do pay dividends – two notable exceptions are Alphabet Inc. and Berkshire Hathaway.

Buybacks do benefit all shareholders to the extent that, when stock is repurchased, shareholders get market value, plus a premium from the company. And if the stock price then rises, those that sell their shares in the open market will see a tangible benefit. Other shareholders who do not sell their shares now may see the price drop and not realize the benefit when they ultimately sell their shares at some point in the future.

Share repurchase programs have always had their advantages and disadvantages, for company management and shareholders alike. But, as their frequency has increased in recent years, the actual value of stock buybacks has come into question. Some corporate finance analysts feel that companies use them as a disingenuous method to inflate certain financial ratios, such as EPS under the auspices of providing a benefit to shareholders. Stock buybacks also enable companies to put upward pressure on share prices by affecting a sudden decrease in their supply.

Investors shouldn't judge a stock based solely on the company's buyback program, though it is worth looking at when you're considering investing. A company that buys its own shares back too aggressively might well be reckless in other areas, while a company that repurchases shares only under the most stringent of circumstances (unreasonably low share price, stock not very closely held) is more likely to truly have its shareholders’ best interests at heart. Remember to also focus on the stalwarts of steady growth, price as a reasonable multiple of earnings and adaptability. That way you'll have a better chance of participating in value creation versus value extraction. (For more, see "How to Profit From Stock Splits and Buybacks.")

Some experts contend that buybacks at current high market levels cause the company to overpay for the stock and are carried out to placate large shareholders. For clients who invest in individual stocks, a knowledgeable financial advisor can help analyze the longer-term prospects of a given stock and can look beyond such short-term corporate actions to realize the actual value of the firm.