My Reconsideration: Why Share Buybacks Are Pointless
Devin Hobbes
About this author:
I suggested in some previous posts (like here) that share buybacks are a good idea. Some further thought on the subject has made me reconsider.
When we buy stock on the open market (i.e., from all sellers that are not the company), the company whose stock we buy benefits only indirectly, if at all. A company's share price (market cap, actually, because it makes no difference if for example a $100 billion company's stock is priced at $50 or $100) matters only when it sells its shares and when another entity tries to buy the company.
In theory, share buybacks should increase the value of the shares that remain outstanding (or in the float if the company doesn't cancel the shares it buys back). There are a couple of general reasons for this view. (1) Given the same investor demand for the shares as existed before the buyback and a lower supply of shares because some have been bought back, the shares should rise in value. (2) A company buying back shares increases some per share figures (like sales and earnings), decreases others (P/E, Price/Sales, etc), and signals to investors a number of things (e.g., management is optimistic about the future, thinks the shares are undervalued, the company is in a good enough financial position to use cash in such a way, etc). It may lead investors to want to buy the shares, thereby increasing the shares' value. That is, a buyback not only decreases supply, it may boost demand.
In practice, it is hard to tell what effect a share buyback actually has. When a company buys back its shares and they rise, we cannot really say that this is the result of the buyback. If the company is doing well, its shares might rise just for that reason, regardless of any buyback. On the other hand, there are plenty of examples of companies buying millions or billions of dollars worth of their shares every year while their stock price drifts ever lower. Maybe the share price would decline faster without the buyback, but there's no good way to tell.
Why do companies buy back their shares? Unless the company decides to go private, it has to be for the shareholders, based on the theoretical reasons mentioned above. This is because from the company's standpoint, the share price does not matter unless the company sells shares. There is no benefit to the company if its shares go higher and no real detriment if its shares go lower, unless it sells shares. When making a secondary share offering (and perhaps selling stock to investors directly - although this doesn't affect anything unless a lot of stock is sold in such a way), the higher the company's market cap, the better for it. That's because it can raise more money. The lower the market cap, the less money the company can raise.
This is not to say that share price does not matter in other circumstances. It does, for it can affect things like, for example, how current and potential customers see the company. A rising share price may keep old customers and help get new ones. A falling share price may do the opposite. But in terms of a share buyback, I don't think share price matters. If the company is doing well and investors think it will continue to do well, the shares will probably rise for the same reason as the company gets new clients. If business is going poorly, the shares will fall for the same reason the company will lose customers. Share buybacks will not help either situation, and, regarding the latter, the money could be better spent more directly, say on advertisements.
I find it a little funny when a company says it's buying back its shares because they are undervalued. That they are undervalued suggests that they will be fairly valued in the future. Why would you want to buy undervalued shares? Silly question, right? Because you want to sell them later for a higher price. That's pretty obvious.
If you want to keep the shares (of a non-dividend paying stock) forever, it doesn't really matter if they're undervalued or overvalued because you'll never sell them and won't suffer a capital gain or loss. It will only matter what your expenditure is. But if you plan to spend $x in total and the only variable is the number of shares you end up buying, it doesn't matter how the shares are valued when you buy them, unless you plan to sell them later. (What's the point of buying and holding a non-dividend paying stock forever? I don't know, and have been wondering about this). It is different with a dividend paying stock, of course, as the more undervalued it is, the better the yield you can get. So buying undervalued stock makes sense, from the investor's point of view - you either want to sell the stock in the future to someone else for a higher price, or you want a good dividend yield if you decide to keep the stock forever.
But does this make sense from the company's point of view? It's buying back shares because it thinks they're undervalued. So it wants to sell them later for a higher price? (Some companies buy back their stock with borrowed money. Can this ever be smart if they don't plan to sell the shares later?) Do you want to invest in such a company? Investors hate having their stake diluted, unless it's for a good reason.
There are three general situations in which a company issues new shares. (1) A development stage company needs extra money for R&D or to build a plant, (2) growth: a partial or all stock merger with or acquisition of another company, or money needed for a new or bigger plant, more ships, trucks, real estate, etc, and (3) survival: the company does not currently have enough cash to sustain its operations. (We can add a fourth reason, but this would be a rare one: the company thinks its shares are overvalued and decides to sell).
A company in situation (1), unless management is stupid, would never have made share buybacks. If management is stupid, the new share offering won't be successful because of the previous buybacks.
A company in situation (3) likely has already seen its share price plunge. Share buybacks in the past, likely for a higher price than the company now offers, do not help. All the banks that had share repurchase programs come to mind here.
Situation (2) is probably the only time when a company can issue new shares and sell them for more than it paid in an earlier buyback. But had it not done the buyback previously, would it really make much of a difference in terms of the company being able to issue more shares now so that it can expand? If investors think the expansion is a good idea, the company's secondary offering will be successful even if it never bought shares back in the past. If investors think it's a lousy idea, past share buybacks will probably not make the new share offering's reception any better. So even here share buybacks may not make sense. When seeking to buy undervalued shares, it seems, a company is better off going after another entity's shares rather than its own.
Instead of spending its money to lower the number of its shares being traded, the company has better options. If providing value for investors is the impetus, maybe giving them the cash instead is better. A share buyback may do nothing for the stock's price. And even if it does, the shareholder has to sell in order to benefit. A dividend, on the other hand, rewards the shareholder and allows him or her to stay invested in the company. The company can also use the cash to service its debt (if it has any), try to hedge its costs (e.g., a beer producer might buy wheat futures), invest in the undervalued shares of another company, or keep it in a safe place for future opportunities or a rainy day. A company in situation (3) might not be in such a dire predicament if it kept the cash rather than buying its own shares.
To put it in a slightly different way:
When you buy shares you either intend to sell them later for more than you paid, or keep them forever. They are of no use to you if you keep them forever unless they pay a dividend. A company cannot pay itself dividends, and the amount of money it saves by not having to pay dividends on canceled shares pales in comparison to how much it costs to cancel the shares. (For example, if the dividend yield on the shares is 5%, it will take 20 years before the company saves money on the transaction if the dividend payout stays the same.) So keeping the shares forever is no benefit to the company. To derive a benefit, it must sell the shares for higher than it paid for them.
Investors like share buybacks because the share price might rise as a result and because their stake in the company increases. That the share price will rise because of a buyback is a questionable assumption. Apart from enjoying a potential rise in the share price (yes, earnings per share increases because there are less shares, but unless the share price goes up correspondingly, you should not care one bit), having a greater stake in a company means having greater voting power. But for most investors, going from having 0.00001% of the vote to 0.000011% does not matter. (One may argue that a smaller share count means more dividend money is available for each share. For example $5 million spread out over 20 million shares will give a bigger payment per share than if it's spread out over 20.5 million shares. I agree. But why couldn't the company have used the money it spent on those 500,000 shares to increase its total dividend amount instead? The end result would be the same - greater payout per share - but the investors who kept the shares would get the extra money rather than the ones who sold). Having a slightly greater stake in the company, then, means squat for most investors.
So, if the company keeps the shares forever, investors get pretty much nothing except greater ownership in a company with less cash (and/or more debt), and the company gets nothing. If the company decides to sell the shares later, on the other hand, the greater voting power derived from the previous buyback is erased. As investors hate dilution, the share price might suffer as well. In the end, a company might end up in a better position because of share buybacks, but not enough to make buybacks better than other options.
What's interesting is that share repurchase programs usually run at full steam when things are good and the share price is rising, and are canceled when things get tough and the share price falls. But the best time to invest in a company, as we learn from the best value investors, is when its share price has tumbled. And this is precisely the time when the company is struggling and can't buy its shares. So much for buy low, sell high.
Management, give me a dividend, pay your firm's debt, or keep a fund for the future if you don't know what to do with the extra cash. If the company's shares are undervalued, use your own money to buy them.
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This article has 15 comments:
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Wefwef
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45 Comments
Nov 19 02:16 AM-
andyn
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120 Comments
Nov 19 08:56 AMIt indicates a lack of opportunities / ideas that the company can use the money for.
Buybacks give a false bottom to stocks and doesnt allow the markets to be do their actual thing.
I think better would be to do a special one-time dividend and give the money directly to the shareholders. (I was recipient of a HUGE dividend from MSFT some years back).
I am thinking of getting back into MSFT but am worried they may now do that stupid YHOO deal.
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dilettantedude
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14 Comments
My Website
Nov 19 12:31 PM-
Kofi Bofah
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72 Comments
My Website
Nov 19 12:56 PMBuybacks should only be used when the stock is cheap.
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BerkeleyBob
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116 Comments
Nov 19 01:12 PM-
the_Bird
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25 Comments
Nov 19 01:48 PM-
Bert Mariani
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1 Comment
Nov 19 06:26 PMYou might as well put the cash in a wheelbarrow and set fire to it. Why spend $ Billions buying back shares that had been sold a long time ago.
Look at GE. They spent $ 28 Billion on buybacks in the last 3-4 years. So what happens - their stock still goes down in price. Then they go begging to Warren Buffet for a $ 5 Billion cash infusion at 10% interest. If they still had that $ 28 Billion that was burning a hole in their pants, they wouldn't have to beg.
The best thing to do is return the cash to the shareholders as a special dividend.
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najdorf
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82 Comments
Nov 19 07:06 PMSince everyone pretty much agrees on liking dividends, lets think about what effect buybacks have on dividends. If a company paying a $2.00 per year dividend buys back and cancels 10 million shares, they now have $20 million in cash that they don't have to pay out (the dividends for the bought-back shares). What will they do with this money? Hmm, maybe a dividend increase?
Of course, some companies don't do that. Some use the $20 million for a more lush executive compensation package and then watch the exec fly the plane into the mountain. These companies misused buybacks.
But what's wrong with a company that buys back shares when shares are unreasonably cheap and only raises dividends with the increased EPS when shares are expensive? The buyback helps to make stock prices more accurate and buoyant, pulls concentrated ownership from speculative weak hands to buy-and-holders, avoids taxes, and provides a more beneficial use for capital than speculative acquisitions or foolish expansions. Even as a yield-driven investor, you want your asset value to be high because you don't pay taxes on asset level and it's always better to have higher asset levels than lower - everything will be sold some day.
Buybacks aren't a panacea because most stocks are often overvalued, especially at those times when management has enough cash on hand to consider buybacks (cyclical tops, usually). Many managements would do better to immediately give shareholders money to invest elsewhere. But if you don't trust the management to invest your money profitably and would prefer a special dividend, why don't you give yourself a special dividend by selling your shares and investing your money elsewhere? The mass of averagish managements in average companies would do better to hold more cash and use it for buybacks and acquisitions when irrational pessimism makes everything cheap. Excellent managements in an excellent businesses should be investing everything back into the business all the time so long as ROIC matches or exceeds alternatives available to shareholders. Buybacks are a way to do this when expansion isn't practical.
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Joe O'Donnell
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10 Comments
Nov 20 12:36 AMBuybacks are a way for a company's management to efficiently give value back to their shareholder base. Think about this -- if you increase the dividend, then all recipients of said dividend have to pay income tax on the increase. If you instead use that money to retire shares, each shareholder owns a larger percentage of the business (and future cash flows) and does NOT have to foot an increased and clearly suboptimal tax burden. The shareholder can realize this stored value when convenient and pay only long-term capital gains on this, as opposed to normal income tax.
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Joe O'Donnell
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10 Comments
Nov 20 12:36 AMBuybacks are a way for a company's management to efficiently give value back to their shareholder base. Think about this -- if you increase the dividend, then all recipients of said dividend have to pay income tax on the increase. If you instead use that money to retire shares, each shareholder owns a larger percentage of the business (and future cash flows) and does NOT have to foot an increased and clearly suboptimal tax burden. The shareholder can realize this stored value when convenient and pay only long-term capital gains on this, as opposed to normal income tax.
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the_Bird
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25 Comments
Nov 20 07:53 AMI'm a fan of cleanliness. Give me cash in my pocket. Give senior execs a fair amount of compensation, but make that transparent. Don't use buybacks to cloud the effect of exactly how much is being spent.
So, yeah, neither good nor bad, inherently - but subject to abuse.
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mahony
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12 Comments
Nov 20 11:27 AMThis whole article seems a bit naive. The buyback is abused (duh) just like every other technique to lift stock prices. Companies announce buybacks at outrageously high value (just plain dumb), buy with one hand while borrowing with the other, fail to follow through on announced buybacks, buy back and then issue new shares shortly thereafter, buy back to counter poor perception and the list goes on. Just because it is poorly executed in many cases, doesn't mean it's bad or doesn't work. In the long run people will prefer the company that increases the profits associated with it's doing business. Lower number of shares increases that profit to price ratio (or lowers P/E), which ultimately is the goal of any owner.
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searcher
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139 Comments
Nov 20 12:12 PMRight! However, "Excellent managements in an excellent businesses should be investing everything back into the business all the time so long as ROIC matches or exceeds alternatives available to shareholders" goes too far as it presupposes all shareholders have the same income and return horizon expectations. Many holders want at least some income from an established business with margins more attractive than alternative investments.
Unfortunately, as already stated, these buybacks, even by well informed and ethical managers tend to be at market tops (at least their stock's top) because they're doing well and flush with cash and high confidence in their future. How could they not believe so, their margins are great, so good that no one else matches their return on investment. Maybe "excellent" management is not enough, possibly prescient, as well, is required.
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Kinabalu
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149 Comments
Nov 20 01:30 PM-
donzelion
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15 Comments
Nov 20 05:27 PMFrom the investor's perspective, the tax arguments on share buybacks v. dividends strikes me as analogous to the Roth IRA v. traditional IRA debate: which is better, current income (dividends) v. deferred income (capital gains)?
Thing is, I make my own tax decisions. I prefer to do it based on my own best judgment, rather than having the companies I invest in do it for me - particularly given the likelihood that they have the interests of someone else at heart. Management compensated by stock options always gains from a share buyback - I might gain to, sometimes. But I prefer my Roth, and I prefer my dividends.