Alphabet Stock Buyback: Why Now?

Looks like I'm not the only person who forgets the new name is Alphabet. Source: Alphabet's quarterly earnings summary/10Q.

Last week, Alphabet reported blowout earnings that topped analyst estimates on both the top and bottom lines. As for revenue, the company reported $18.68 billion versus consensus of $18.53 billion. As for the bottom line, the company beat per-share expectations of $7.21 by posting earnings of $7.35.

As a result of the beat, strongly led by a better-than-expected year-on-year aggregate growth rate of 23% (analysts expected a smaller 18.6% growth), the highest showing in more than a year, the company's C shares shot up double digits, pushing the company's value briefly to about $500 billion.

Further adding to investor ebullience was an announced stock buyback. After years of being faulted for being stingy with its growing cash pile, the board authorized a repurchase plan of up to $5,099,019,515.59 in stock, a play on the new name: The square root of 26, the number of letters in the alphabet, is 5.09901951559. Alphabet then raised that figure to the ninth power for its announced buyback.

The question, as Alphabet pushes past all-time highs, is why now?

Stock buybacks: Here's why companies do themWhen it comes to returning cash to shareholders, there are two ways companies do it. On one hand, the company can make dividend distributions (quarterly, annually, or even on a one-time "special" basis) to attract income-focused clientele. The downside with these distributions is that they're taxed on both the corporate level and on the personal level -- although on the personal level, they are generally granted a 15% income-tax rate.

The second way is by stock buybacks. All investors, including income investors, would prefer investing in a company that's growing income per share. By buying back shares, a company increases EPS, ceteris paribus, as fewer shares are outstanding. In addition, stock buybacks aren't subject to double taxation, providing investors with more returns by keeping them from being transferred to Uncle Sam's coffers.

Buybacks have perverse incentivesIn addition, and perhaps as a perverse incentive, stock buybacks tend to help members of the C-suite in two ways: Many bonuses are given in the form of stock-based compensation, or are calculated based on stock appreciation. Retiring shares directly helps these recipients pull in the multimillion-dollar bonuses many are used to receiving, as increases in EPS (earlier explained) generally also leads to higher stock prices.

Also, stock buybacks offset the effects of dilution on stock-based compensation, so regular investors don't quite feel the effects of an expanded share base, as many investors don't quite follow cash balances and shares outstanding quite like they do earnings per share. However, buybacks can also divert much-needed cash from investing in talented employees and research and development.

An extreme example of "death by buyback" is IBM , which has spent more than $100 billion buying its own stock since 2000, using a debt-fueled spree in an attempt to prop up its EPS and stock price. Currently, the company's total market cap is only $141 billion, down from the $200 billion valuation the company enjoyed in the early aughts, as the company hasn't grown revenue in a meaningful way since 2008.

The problem with stock buybacksTo be fair, and in spite of perverse incentives, a well-executed share buyback program may be the best use of capital in a low-interest environment. The problem with this line of reasoning is that companies are, historically, pretty bad at stock buybacks. The term "dumb money" has traditionally been used to denote investments by low-wealth retail investors but could equally be applied to companies' buybacks.

See the following chart, from FactSet, for insight into how bad companies have been at buying back stock:

Source: FactSet

Digging into that data, you'll notice the tremendous drop in the amount of buybacks and how the number of companies buying back stock rises and falls in tandem with the S&P 500 index. That's not how a rational, value-accretive buyback policy should work. In fact, this is the exact opposite of how a smart buyback policy should work. In 2009, companies should have been buying back stock hand over fist, taking advantage of short-sighted sellers. In actuality, very few did.

Could Google, ahem, Alphabet be different?Which brings us to Alphabet. On the basis of two strong quarterly reports, the company has grown its total market cap from the neighborhood of $360 billion in July to currently knocking on $500 billion. And while investors should be encouraged with this performance, the authorized amount that now buys back a little over 1% of shares outstanding would have repurchased 1.5% just a few months ago and over 5% during the nadir of 2009.

There are some caveats, however: Simply authorizing a buyback doesn't mean you have to complete the buyback. Alphabet could hold on to this cash until a rare panic-filled dip occurs to take advantage of Wall Street's irrationality. In addition, companies buy back stock on the basis of future projections, and if you feel as a company that your stock is undervalued -- if Google decides to use the cash, let's just hope they're right. Unfortunately, if past is prologue, they won't be.

The article Alphabet Stock Buyback: Why Now? originally appeared on Fool.com.

Jamal Carnette has no position in any stocks mentioned and feels like he should mention he's been [very] wrong before and hope Google is right in regards to their stock buyback. The Motley Fool owns shares of and recommends Alphabet (A shares) and Alphabet (C shares). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.