Kurtis Hemmerling's  Instablog

How can a company return firm capital to the shareholder without incurring taxes on the investor and at the same time boost valuations? Then answer is share buybacks. A company goes into the open market and buys back shares…and destroys them to increase shareholder value. Simple math tells you how profitable and powerful this tool can be.

Big Widgets Inc. has 10 million shares outstanding at $50 apiece. If the company buys back 10% of all outstanding shares, the valuation increases proportionately by 10%. Either the shares will have deeper value at $50 per share thus providing downside protection or more probably the shares will increase by 10% and keep similar valuation ratios. Big Widgets is looking out for your best interests…right? Uh…maybe not.

(Part 1 of this series can be viewed here)

The Dark Side of Buybacks

First we need to consider the big conceptual picture before explaining the reason why some CEO's prefer to buy back shares instead of paying dividends. Recall in Part 1 that unless dividends - or the threat of dividends exist - it is difficult to value shares at all. Ratios based on earnings, revenue or assets are almost meaningless unless shareholder's have a connection to firm equity. If you are never allowed to access the earnings, what good is a low price to earnings ratio? In that sense, any seeming benefit to company valuation ratios from a share buyback is moot unless there is an eventual transfer of wealth from firm to shares.

So while share buybacks may increase certain ratios - of what value is that ratio if it doesn't translate into cash in the shareholders pocket? If the stock had a price to earnings ratio of 20 before the buyback and 10 after the buyback, how does that help shareholders when management is unwilling to issue dividends? With no access to the profit, any ratio built on profit is 'feel good' only. But let's assume that at some future point in time there will be the return of firm capital to the shareholder in the form of a dividend. Are the interests of shareholders and management now aligned?

Buybacks and Employee Compensation

Share buybacks are great for shareholders and must be rooted in some deep form of management altruism…right? Not necessarily. In 2011, companies in the S&P 500 purchased back $409 billion…a staggering amount indeed! But did this go into shareholder pockets? Little, if any, actually trickled back to shareholders. Why? Because this amount was just enough to cover up employee stock options. If the shares were not repurchased, there would have been share dilution.

Consider the move made by Apple (AAPL)…

"The board has authorized the repurchase of $10 billion of stock over the next 3 fiscal years with the primary objective of neutralizing dilution from future grants through Apple's employee equity programs."

Shareholders were giving each other high 5's for this exciting repurchase program. But what effect would it have overall? $10 billion of cash would be drained from the company and the amount of outstanding shares would be the same. Should we really be so pleased that Apple was making a complicated process for giving $10 billion in bonuses? Really, this joint announcement should drop the market cap by $10 billion dollars and not boost it.

Share buybacks used to be taken as a signal that management felt confident in its future growth prospects and that current shares were undervalued. Shares were bought back at cheap prices to make wise use of cash. Now it is a largely unregulated method to cover up cash leaving the building in the pockets of employees. The process is to hand out stock options like candy and then cover it up through share re-purchase. To see that this is so, you only need to dig through the quarterly and annual reports and see how many options are being granted, how many shares were repurchased, and track the net difference in outstanding shares between last year and this year. Management can create incentives and funnel money out of the firm while being cheered on by shareholders as dilution is replaced by cash destruction.

But there is more…

Buybacks and Executive Compensation

Guess who else can get compensated with stock options? You guessed it… executives. Imagine for a moment that you are an executive at a big firm with $1 million in stock options. At the moment you have the choice to take $1 billion in cash and give it back to shareholders as a dividend which will lower share prices as equity is removed. Remember that your executive options are not adjusted for the removal of dividends like common stock options. Dividends paid out mean you lose out on a personal bonus. Or you can take the $1 billion and initiate a share buyback program thus creating lift for share prices so that you can maximize your personal return on executive options. If you time it just right with the repurchase announcement, you could ride a nice momentum price wave for a really big bonus even though outstanding shares will stay the same once all employee/executive option dilution and buybacks cancel each other out. Which of the two choices will you choose?

Studies have shown that there is a clear correlation between executive options and stock buybacks…these two go hand in hand. The higher level the executive options are the bigger the buyback program that takes place. In fact, when you hear of a buyback program, share prices often rise. But studies are showing that dilution is often not far behind as share prices peak and fall into negative territory. If you had the legal ability to push prices up before giving yourself a share price related compensation package, and had the ability to dress it up as a positive for the average shareholder…would you do it?

But, you may counter, smart management buys when prices are low thus maximizing my value as well. Is that really so? Studies have found little link between undervaluation and stock buybacks. Furthermore, companies prefer to engage in buybacks in a way that temporarily shoots up share prices - in the open market. Is the entire market progressively moving towards being undervalued? If not, why the move towards share buybacks instead of dividends? And if management is so concerned about getting the best prices for shareholders, why not buyback shares through public auctions or tender offers instead of the public market which gives a bad average price? Or do you think it more likely they self-interest is involved? I'll let you be the judge of that one. And furthermore, I don't trust the average company executive to take judge the appropriate valuation levels of the company. Let business managers do their jobs and let investment experts do theirs. I don't show up and tell you how to flip hamburgers so don't decide what a good value to buyback shares is for me.

And there is one more aspect to buybacks you should consider…how it alters ratios. To find out how buybacks can remove equity from a company and at the same time boost bonuses read the rest of the article at here at Portfolio Cafe.