Are Share Buybacks Actually Good For Investors?

The continued expansion of corporate stock buybacks in the S&P 500 is one of the biggest stories in the stock market over the past couple of years.

U.S. companies have bought back nearly $1 trillion in stock over the past 10 quarters, by far the largest buyback boom in history.

Somewhat lost in the media coverage, however, is a key thought: Is this a good thing for shareholders?

Companies can return excess cash to shareholders in two ways: by paying dividends or by buying back stock. Recently, companies have been favoring buybacks … by huge amounts. S&P 500 index members repurchased $117.7 billion in stock in the first quarter of 2007, up 17.5% from year-ago levels and 275% from the first quarter of 2001. Dividends, meanwhile, were up just 9.52% and 72.39% over the same time frame.

What’s telling about those numbers is that they came AFTER the implementation of the dividend tax cut, which improved the tax treatment of dividends to place them on-par with capital gains.

Why the discrepancy? Is it because buybacks preserve corporate flexibility and allow shareholders to defer taxation on their gains? Maybe.

But it can’t hurt that buybacks funnel directly into executive compensation. Often, year-end executive bonuses are tied to stock prices … so by boosting the share price, executives get a bit of extra cash at Christmas. More importantly, buybacks boost the value of unvested options, leading to outsize paybacks down the road. Dividends, meanwhile, are just money out the door.

Buffett and others have criticized the practice. Shareholders have even sued companies for engaging in buybacks while insiders sold shares (see Sprint Nextel, for example). Nonetheless, I can’t help but feel that the issue gets short-shrift in the media, which treats buybacks as fully shareholder friendly actions. It is, as always, more complicated than that.

Comments

[tradeorfade:]

when everyone in the investing public wonders where all the money went, they can look up this article. think about a 30% correction and the wasted money executives spent to boost their own payouts. there will be dozens if not hundreds of lawsuits over this in the next couple of years.

2007 Jun 11 12:44 PM

[euro:]

Just a couple of things...

If you are going to cite the Oracle of Omaha, you should first learn how to spell his name.

You should then have a fair synopsis of what he's said about buybacks. He has been critical of them when shares have been repurchased north of a company's conservatively-calcula... NAV by managers looking to goose s/t EPS. His criticism of that value-destroying process is not a blanket negative statement about buybacks. He famously prompted the Graham family to repurchase shares in WPO when it was clearly selling way below fair value in the 1970's.

2007 Jun 11 01:37 PM

[SA Editor J...:]

Thanks for pointing that out - I corrected the spelling of the Oracle's name :-)

2007 Jun 11 01:54 PM

[billb:]

You're making the assumption that buy backs increase the price of shares. Is this true? If so, then I would say that investors could potentially make a killing by buying shares of companies that announce buy backs. I think it has been proven that this isn't necessarily true. Why bellyache if this is a sure thing?

2007 Jun 11 05:14 PM

[kdo:]

Neither buybacks nor dividends actually increase any value of anything for the shareholder. Dividend payments are often accompanied by -- share price drops. If you understand how to value equity, you understand these are just capital allocation decisions. Over time, share buybacks are an investment in themselves, which should hopefully beat the return on cash. Share buybacks may prove to be a great thing for the company to have done. They may not. They should return somewhere close the cost of equity - just like dividends redeployed into the stock market would. Both have their use and misuse.

2007 Jun 13 01:15 AM

[Tyler McKinna:]

Interesting article.
I wrote about the same thing a little while ago.
It's nice to see someone wit the same opinion as me. Here is my article:

2007 Jun 11 06:16 PM

[Sonia Mirza:]

1. If the buyback was due to the company's perception that their shares are undervalued - somewhat a signal that they're undervalued in itself, yes.

2. If it's merely a play on #1 to artificially raise the price (since investors take this signal as a positive one) and have the general public jump on the bandwagon, and/or S/T EPS target maintenance then, no it's not good for shareholders...

3. If you have no alternative good use of FCF (that is cannot invest it in something that would potentially grow the company/value, therefore benefitting the SH as well), dividends is a direct cash provision. I am not sure how buybacks add direct value to SH other than price appreciation - perhaps I'm having a rather odd brainfart.

2007 Jun 11 07:45 PM

[wixeywaxy:]

I don't think there is any correlation of stock buy backs to stock price increase in a short term perspective. Perhaps there are exceptions but my observations would point to just the opposite, why I don't know. Longer term the shares should go up because the EPS will go up everything else being equal. Those of you who don't like buy backs should avoid companies that are doing it because they tend to continue the practice. I, for one, think that in many cases it's a very good strategy. Vic

2007 Jun 12 02:53 PM

[Ray Wollney:]

It depends on the reason for the buy back.

If a company is buying back the stock that reduces the share count that benefits the shareholders.

However if a company is buying back shares that it issued to it's executives and employees due to the exercising of employee stock options (ESOs), at lower prices than the company is paying to buy the shares back, then that is not beneficial to shareholders. Quite to the contrary. In other words if the executive or employee was granted ESOs to buy the stock at say 20 and the stock rises to say 40 and he exercises the options and the company wants to avoid dilution so it buys the stock back at 40 this is not good for shareholders.

According to Albert Meyer a CPA and former accounting professor and the head of Bastiat Capital the difference between 20 that the company was obligated to sell the stock for and the 40 it paid to get it back is in reality a deferred compensation expense.

A good example of this according to Mr. Meyer is Dell which had a net income of 19 billion over the past ten years. However shareholder equity only increased by 3 billion. What happened to the other 16 billion? It was spent buying the stock back that it had issued to executives and employees. This was cash out the window.

I would suggest that anyone interested in this subject to go to google and look up Albert Meyer interview-Bastiat Capital. It is quite revealing

2007 Jun 12 09:48 PM