Wrap your head around this: Companies spent an estimated $477 billion on share buybacks last year. That’s enough to buy every NFL team 12 times over, run the federal government for 50 days or host the next nine Olympic Games with several billion left to spare. This year, companies are expected to ramp up buybacks by 35%, according to Goldman Sachs.
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But is real value created for shareholders when companies buy back their stock?
The short answer: In most cases, no. Buybacks act as a short-term stimulus for a company’s stock price to drive earnings on a quarterly basis and please Wall Street.
“Buybacks are short-term oriented and mortgage the future of the company,” said Brian Sozzi, chief stock strategist for Belus Capital Advisors. And increasingly they’re used to stave off demands from activist investors like Carl Ichan.
Yes, share buybacks can prop up the stock price in the short term by decreasing the number of shares outstanding. But buybacks are subject to market whims. When poor economic data hit the tape or some other adverse event comes out of left field to strike down the market, share buybacks aren’t going to insulate your stock.
Worse, if there are problems with a company’s business, share buybacks won’t make up for those underlying issues. Take Staples (NASDAQ:SPLS) as an example. Staples has been buying back stock in droves, purchasing nearly 21 million shares in just the past year as its business struggles.
The office supply store says it plans to close 225 stores over the next two years and shrink the size of current stores by half to bolster profits. The move comes as sales continue to precipitously decline. The retailer reported a 7% drop in stores open for a year or longer in North American during the fourth quarter. So-called same-store sales in North America have fallen for six out of the past seven years and Staples expects sales to slip again this year. Meanwhile analysts expect earnings to contract this year and next. Share repurchases haven’t been enough to stem the decline in Staples’s business. Since last August, the stock has plunged 27%.
What’s more, share buybacks are unpredictable. Companies may not repurchase as many shares as they say they will in their buyback announcements. During the financial crisis, dozens of companies suspended buybacks, but continued paying dividends. “Unlike dividends, share buybacks only return cash to those shareholders who sell their stock and reduce or eliminate their position in the company,” said David Blitzer, managing director and chairman of the S&P Index Committee. Also, in many cases share buybacks don’t reduce share count -- they simply offset stock options that are given to employees or executives as part of compensation packages. If stock repurchases do reduce share count, it can increase ownership clout by increasing the percentage of shares executives possess, thereby increasing executives’ control over the company.
So why are companies buying back shares at such a quick clip nowadays?
In short, companies are reluctant to invest their cash hoards in hiring people, raising salaries or expanding their businesses until they feel more confident about the economic recovery. Indeed, in recent quarters, companies have shown difficulty boosting earnings through sales growth. So some have resorted to financial engineering through buybacks to manufacture an increase in earnings per share and create artificial shareholder wealth in the short term.
“Instead of generating 20% earnings growth now, you buy back shares and boost earnings growth to 25%,” said Sozzi.
“But that’s money you could have reinvested in your business. Since you didn’t reinvest in your business, next year your earnings growth falls to 10% to 15%. The market won’t like it and your stock will get hit. So what value did you create?”
If economic growth falls short again this year, increasing earnings through sales growth will prove tough yet again, causing execs to fall back on – you guessed it -- share buybacks.
And this year it will take more cash to buy back stock to create the same impact as last year on share price, according to S&P Capital IQ’s Howard Silverblatt. This year if a company wants to buy back the same number of shares as last year, it will have to spend 30% more. Stock repurchases are generally valuable, however, when companies purchase shares on sale. Billionaire investor Warren Buffett favors repurchases when two conditions are met: first, a company has ample funds to take care of daily business operations; second, its stock is selling at a large discount to the company’s intrinsic business value, conservatively calculated.
If the stock isn’t trading at a discount, a better use of cash in most instances would be investing back in the business for stronger future growth. If companies don’t invest for the future, they could lose market share to competitors and be caught flatfooted when the economy turns, hurting sales and profits.
If there’s no reason for the company to invest the cash back in its business, then the company could give the cash back to shareholders through dividends, not buybacks. Unlike share buybacks, dividends are predictable and ensure cash is in the hands of investors.
Besides, no one ever disputed the value of cash in hand.