Image source: Alphabet.
Alphabet (GOOG -0.34%) (GOOGL -0.44%) has recently announced a share buyback program -- the first one in the company's history. Buybacks typically generate strong opinions within the investment community: While some analysts consider them a smart and efficient way to return capital to shareholders, critics believe share repurchase programs are just a corporate artifice to inflate earnings per share.
At the end of the day, it all depends on the particular case, so let's take a look at Alphabet's share buyback program and what it means for investors in the company.
Doing it Alphabet's way
Alphabet announced a very particular buyback program: The company will be repurchasing up to $5,099,019,513.59 of its class C stock, commencing in the fourth quarter of 2015. The number of shares in the buyback program equals the square root of 26 -- the amount of letters in the alphabet -- times a billion. Even serious capital allocation decisions can incorporate quirky mathematical jokes when it comes to Alphabet.
Leaving these considerations aside, the buyback program amounts to roughly 1% of the company's market capitalization, so it will have a modest impact in terms of overall capital allocation. Similarly, the business brought in nearly $11.4 billion in free cash flow during 2014, so Alphabet has more than enough money to finance buybacks and continue investing in all kinds of projects and acquisitions.
While the buyback amount is not particularly big (relatively speaking), it can be interpreted as an important signal for investors. Companies tend to reinvest all of their money when they are young and need that capital to grow. As a business matures, if the company produces more cash than it needs, it typically starts returning capital to investors via buybacks and/or dividends.
Since Alphabet brings in tons of money on a recurrent basis, investors should not be surprised to see management increasing its capital distributions over the years -- maybe announcing bigger repurchases and perhaps even starting a dividend policy in the not-so-distant future.
Welcome to the big boys club
The tech industry is traditionally considered a high-growth area, so many smaller companies in the business typically retain most of their cash flow. On the other hand, big industry players such as Apple (AAPL 1.03%) and Microsoft (MSFT -0.08%) produce far more cash than they need, and they reward investors with generous capital distributions.
Apple has a truly gargantuan capital distribution program. The company allocated $11.6 billion to dividends and $35.3 billion to buybacks over the year that ended in September 2015, for a total of $46.9 billion in capital distributions. Management has already completed $143 billion of Apple's $200 billion capital distribution plan.
Microsoft has long trajectory of dividend growth; the company has raised dividends in each and every year since it made its first payout in 2003. It announced a big 16% dividend increase for 2015, and its stock offers a respectable yield of 2.8% at current prices. The company allocated $2.5 billion to dividends and $4.7 billion to stock buybacks last quarter, for a total of $7.2 billion in capital distributions during the period.
Share buybacks reduce the amount of shares outstanding, meaning earnings per share can grow at a faster rate than total company-level net earnings. Even better, if the stock is yielding solid returns, management is investing that money in a profitable asset.
This is the case when it comes to both Apple and Microsoft. Both companies have substantially reduced the amount of shares outstanding over the last five years, and investors have been well served by this decision, since Apple and Microsoft stock have been profitable investments over that period.
AAPL Average Diluted Shares Outstanding (Quarterly) data by YCharts.
What this means for investors in Alphabet
Alphabet is an undisputed leader in online advertising, and the business is performing remarkably well from a financial point of view. Constant-currency revenue grew 21% during the third quarter, and the company makes profit margins in the neighborhood of 25% of sales at the operating level. Everything indicates that, just like Apple and Microsoft, Alphabet stock should deliver solid returns in the years ahead.
Since the company makes much more cash than it needs to reinvest in operations and acquisitions, management is doing the right thing by allocating that money to a sound investment: Alphabet stock itself.
