Share Buybacks: Much Less Than Meets the Eye

Investors love share buybacks. As they should. Done properly, they can be a great way to deliver shareholder value.

Companies love buybacks, too. S&P 500 companies have spent $1.4 trillion on buybacks since the start of 2008, according to S&P.

But The Wall Street Journal recently wrote something curious (emphasis mine):

Aggregate shares outstanding amounted to 299.1 billion [in the third quarter], which is the lowest level since the fourth quarter of 2008. Since 2005, the index has actually averaged year-over-year quarterly dilution of 2.7%.

This took me aback. Despite spending more than a trillion dollars on share buybacks in the past four years, total shares outstanding actually increased since 2005. And that isn't due to share splits that would distort the numbers. Total shares outstanding really, truly rose.

I did some digging to find out more. Taking current S&P companies that were around at the start of 2007 (there are 474 of them), here's how the split-adjusted total shares outstanding count has changed over the past five years:

S&P Shares Outstanding, January 2007

S&P Shares Outstanding, September 2012

282 billion

292 billion

Sources: S&P Capital IQ, author's calculations.

During a period when companies spent more than $1 trillion on buybacks, shares outstanding rose by 10 billion.

What's going on here?

There are three explanations.

One is that while companies buy back a lot of shares, they also issue shares to make acquisitions. Take Bank of America (NYSE: BAC  ) . It issued a lot of stock in 2008 to finance its purchase of Merrill Lynch. So even though the bank repurchased $3.8 billion of its own stock in 2007, shares outstanding increased.

There's nothing inherently wrong with issuing shares to buy a company. But for a company to repurchase stock and then issue new stock soon after to make an acquisition doesn't make a lot of sense. When management repurchases stock, it is effectively telling shareholders that its stock is so undervalued that the company won't find a better investment opportunity elsewhere if it instead paid a dividend. When management issues stock to purchase a company, it is effectively arguing that shares are valued so richly that it can afford to use them as a currency. It's hard to reconcile the two.

Companies also issued gobs of new shares during the financial crisis to raise capital. Bank of America, Citigroup (NYSE: C  ) , Goldman Sachs (NYSE: GS  ) , AIG (NYSE: AIG  ) , and others had to issue new stock as the banking system crashed. Most did so at measly prices, more than offsetting any buybacks done in the previous decade. It was a perfect example of buy high, sell low.

Netflix (NASDAQ: NFLX  ) is one of the most egregious examples. In 2011 it spent $199 million buying back its stock for an average price of $222 a share, and then it sold shares back to the market a few months later for $70 each to raise cash. "Netflix effectively flushed $140 million of shareholder wealth down the drain in nine months flat," I wrote at the time. "That's the equivalent of losing 1.3 million subscribers for a year."

A third reason shares outstanding rose is that companies issue shares or options to management as compensation and use buybacks to sop up the new supply.

The Wall Street Journal recently used eBay (NASDAQ: EBAY  ) as an example:

On July 18, for example, eBay reported it had bought back $355 million of stock during the second quarter and would repurchase $2 billion additional shares. The primary objective, the company said, was to offset the additional shares being issued as compensation.

"If you're asking yourself, 'Wait, so buybacks can be used as a tool to transfer shareholder money to the executives?,'" blogger Josh Brown wrote last fall, "then you've got it figured out, that's exactly what they can be used for. And they often are."

There's nothing intently wrong with this, either -- just as long as shareholders know what's going on.

The textbooks say share buybacks create value by decreasing the number of shares outstanding. I'd add an asterisk to that statement: They decrease the number of shares outstanding, all else equal. Unfortunately, all else rarely is.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 15, 2013, at 7:28 AM, td67 wrote:

    This is exactly my problem with Bank America. They have 10.8 B shares o/s and Sr. mgt continues to flip their option shares EVERY month to the tune of 100,000 shrs per month.

    The shareholders take the pain and mgt. continues to live their Country Club lives. The board of directors is supposed to represent share holders but to continues to allow this to go on and I haven't seen any "Claw" backs for all those excessive bonuses based on earning that later cost us ( the share holders) 10's of billions of dollars. Then the attorney's sue for $100's of MM and make 10 's of Mm and share holder gets .43 cents per share to compensate for his loss.

    JPM only has 3.8 MM shares o/s and C only has 2.9 MM , BAC has 3 times as many and officers keep dumping.

    We need an all NEW BOARD except Powell.

  • Report this Comment On January 15, 2013, at 10:06 AM, slpmn wrote:

    Great example of how large corporations are managed for the benefit of the executives, not their owners. It's all about Earnings Per Share and making sure that executive options and stock grants don't have a measureable dilutive impact.

    For the most part, excess cash on the balance sheet doesn't impact a company's value (i.e. they don't get credit for it in the stock price when they have a lot and they don't get penalized when it goes down), so it makes perfect sense to use it to buy back shares used to pay the excutive team. Keeps EPS stable and creates a fiction that using options and stock grants is a cost free way of paying executives. The eBay example is spot-on, and I would add extremely common. They could have used almost any SP 500 company and found the same thing.

    The textbooks are just wrong on this - in the real world, there is a huge difference between stock buybacks and dividends. We need more of the latter and less of the former.

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