In the old days, cash was king. And in the realm of barely alive startups, it still is. But in recent decades, some companies have found themselves in a not-so-common quandary -- they have too much cash.
What to do with it?
Paying dividends, reducing debt, making acquisitions, undertaking capital expenditures, or buying back stock are the usual suspects. Peter Lynch likes that last one. In his classic One Up on Wall Street, he lists share buybacks as one of the favorable attributes he looks for when buying into companies. He argues that buybacks are "the simplest and best way a company can reward its investors."
Why? Because of the accretive effect on earnings per share. Reducing shares outstanding means increasing EPS.
An article in the May 31 Wall Street Journal points out that cash and "near cash" (cash equivalents, trading assets, and the like) held on balance sheets by all companies in the S&P 500 index, as tracked by Thomson Financial, had a year-over-year increase of 10.4% in the first quarter to $766 billion. The biggest increase for the use of that cash was share buybacks, accounting for 3.1% one year ago and 8% in this year's first quarter.
The article goes on to mention that Dell (NASDAQ:DELL), Yahoo (NASDAQ:YHOO), and Home Depot (NYSE:HD) had buybacks of $10 billion, $3 billion, and $2 billion, respectively.
Analysts quoted in the article say that "the buyback trend is a mixed development." They note that companies less than confident about growth will buy back shares instead of use the cash for capital expenditures or diversify through acquisitions.
Companies are always faced with options in deciding where to allocate capital, and the projected returns on these options vary. Management's responsibility, as it relates to shareholders, is to select the project or activity that should yield the highest return. This may come in the form of dividends, a pursuit of capital expansion, or an acquisition activity. If a company feels that its securities are significantly undervalued, a share repurchase could enrich its shareholders just as well as the other options would, if not more so.
While buybacks generally get favorable reviews, acquisitions into unrelated businesses don't. A good number of mergers result in companies whose sum is no more valuable than their respective parts. In other words, a lot of acquisitions don't work out. Worse still, most acquisitions involve some premium over market price. Lynch has a word for such ill-fated diversifications through acquisition: diworsification. "[I]nstead of buying back shares or raising dividends," he says, "profitable companies often prefer to blow the money on foolish acquisitions." That's foolish with a small "f," folks.
That said, if a company determines that the best use for excess cash is share repurchases, it should act no differently than any savvy value investor would, by buying at a significant discount to intrinsic value. Otherwise, we're looking at yet another case of throwing good money after bad.
To read more about other cash cows, saunter out into the Foolish pasture for "Claire's Cash Quandary."
Fool contributor Chris Cather owns none of the stocks mentioned and has a thing for financial-statement analysis.
