Share repurchases supposedly rank right up there with dividends as a means of increasing shareholder value. But I've come to the opinion that they're little more than a tool for management to massage earnings, and I no longer see them as a positive sign for a stock.
Creating a quick boost in share price via a buyback can mask other problems. And if management really is so keen on the prospects of their company, shouldn't they keep the money in the company? As for the benefit to individual shareholders, it's not all it's cracked up to be.
The theory behind a share buyback is that a company is investing in itself. With oodles of cash on hand, there's supposedly no better place to put that money to work than buying back its own stock. ExxonMobil (NYSE: XOM ) , for example, is so flush with cash from its oil profits that it has bought back more than $100 billion in shares since 2004.
Buybacks are seen as relatively benign maneuvers that reduce shares outstanding, thus distributing future profits to a smaller pool of owners. According to Standard & Poor's, companies in the S&P 500 spent $141 billion on share buybacks in 2007 -- more than twice as much as they earned in profits that year. Moreover, some studies suggest that companies that buy back their shares have outperformed the market by about 3 percentage points a year.
Certainly the market loves a buyback. Anadarko Petroleum (NYSE: APC ) announced a $5 billion buyback in August and shares jumped 8% in the days following the announcement. And Oracle (Nasdaq: ORCL ) just signed on to buy back $8 billion of stock, joining Microsoft (Nasdaq: MSFT ) , Hewlett-Packard (NYSE: HPQ ) , and Nike (NYSE: NKE ) .
While buybacks are considered a bullish signal that management is confident about the company's future, real confidence would have managers keeping the money in the company instead of "returning" it to the shareholders. Although some make the claim that buybacks are a more tax-efficient means of distributing capital to shareholders, the fact is that the shareholders that benefit most from a buyback are those who sell. Those shareholders that stay realize only the indirect benefit of owning an infinitesimally bigger piece of the overall pie.
It's no surprise that many institutional shareholders like buybacks, as they tend not to be as worried about cash flow. They're looking to maximize value for their own shareholders, and in some cases, seeing the share price rise quickly gives them a chance to cash out at a profit.
Higher earnings at a price
The argument that a buyback boosts earnings per share is true, but it's an ephemeral manipulation that can be used to mask other problems. Reducing the number of shares outstanding when real earnings are falling can easily produce false increases in EPS. Too often, the repurchases only offset the dilutive effects of stock options.
Timing of buybacks also remains a key consideration, and, unfortunately, buybacks are made at prices that are too high. Sears Holdings (Nasdaq: SHLD ) , for example, repurchased 13.4 million of its outstanding shares in the year that ended in August at a cost of $1.5 billion, or an average of around $112 each. The stock recently traded under $50 a stub.
The only real spending power a shareholder can earn is through dividends. In fact, the vast majority of gains from stocks over the past 130 years have come from reinvested dividends. In fact, analysts James Early and Andy Cross at Motley Fool Income Investor look for strong dividend payers regardless of market conditions, ones that return real profits to shareholders while providing capital returns over the long term.
With the markets tanking faster than companies can approve share repurchase programs, they're going to come under increasing pressure to prove that the buyback is more than just a means of propping up the stock or helping management make their bonus plan goals.
Of course, there are cases where a buyback is not a cheap magician's stunt. But for me, I'm going to presume them guilty as charged until they can prove their innocence.
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