Stock Buybacks – Legitimate Use of Corporate Cash

May 2, 2022

Stock buybacks are again in the news as senators and even President Biden have shown interest in supporting proposals to limit them. From potentially taxing buybacks to adding other limits, stock buybacks have received much attention in the last year. Why all the fuss?

What Are Stock Buybacks?

The name says it all. A buyback is when a publicly-traded company repurchases its shares. It is simply a method for companies to distribute cash to shareholders. These repurchases are often done on the open market, i.e., regular trading. If you sell 100 shares of Apple, for example, the buyer on the other end could be a fellow investor or Apple itself.

Companies can also use a so-called Dutch auction strategy, wherein they offer to buy a set number of shares in a given price range. For example, company ABC may offer to buy back $1 million worth of shares for $10 to $15 per share. Shareholders then can submit some or all of their shares at a given price within that range. Shares are purchased starting at the low end of the range and moving up until the buyback limit is reached.

Why Do Companies Use Buybacks?

There is no single reason why companies choose to execute buyback plans, but the following are some of the most common:

  • Offsetting the increase in shares outstanding due to equity compensation. Many companies use equity compensation to reward employees – e.g., stock options, restricted stock, or employee stock ownership plans. Every year new shares of stock are issued under these plans. Absent any buyback activity, the number of outstanding shares for a company would increase annually. A higher share count is a drag on per-share earnings growth, so companies often choose to offset this headwind. Apple, for example, has issued on average 120 million shares in each of the last three years due to various equity compensation plans. They have offset this drag (and then some!) by repurchasing about 985 million shares per year.

  • A belief that the company’s shares are undervalued. This is Warren Buffett’s favorite reason for buying back shares. Buying shares for less than what you believe they are worth is the foundation of value investing. It also enhances the per-share value for remaining shareholders. Of course, this assumes that one’s estimate of the shares’ true value is accurate.

  • A lack of growth prospects in which to invest. Most companies will invest in growth projects if they are deemed reasonable and have a decent chance of success (there are no guarantees). These could involve expanding capacity, acquisitions, entry into a new business line, etc. This is how most businesses grow. Management teams are constantly searching for new opportunities by which they can enhance the company’s overall value. If there are no such options, companies have three choices with any cash left over after all their obligations have been fulfilled – holding the excess cash, increasing the dividend, or buying back shares.

Assessing the Options for Cash

Holding excess cash on the balance sheet is certainly an option, but many companies don’t want their cash holdings to become excessive (though “excessive” is certainly a vaguely defined notion). There is something of a stigma (undeserved, I would argue) to sitting on a large cash pile. Many view it as a failing on the part of management (“why don’t they do something?”).

Increasing (or initiating) a dividend is certainly an option, but management groups tend to tread cautiously. They don’t want to increase the dividend so much that it will be onerous in the future. After all, though currently flush with cash, that situation may not last. A special, one-time dividend is also an option, but historically those do not materially impact the long-term value of a company’s stock.

All of this leads us to the buyback. It is easy to implement and can be turned off if circumstances change or a better opportunity comes along that increases the company’s per-share stock value. Seems like a simple decision, no?

The Arguments Against

The two main arguments against buybacks are that they take away from reinvesting in the business and are used to boost executive pay by increasing per-share earnings growth. To be clear, both possibilities certainly exist. But in both cases, I’d argue they can only work for so long.

A company that chronically underinvests in its own business will soon fall behind its competition (or face new entrants that sense an opportunity). Likewise, financial engineering can work in the short run but will require more and more capital to keep the sugar high going. As a result, it eventually will become unsustainable. Still, the threat of the above issues is enough for some to call for restrictions or penalties on stock buybacks.

The Recent Proposal

Interestingly, the most recent buyback proposal does not call for a buyback tax. Instead, it seeks to limit executives’ ability to sell shares after a buyback is announced - a three-year freeze on insider sales, to be specific. The theory is that it will force companies to only undertake buybacks after careful thought and consideration and ensure that executives truly take a long-term view. It is unclear if this would impact 10b5-1 plans or not.

Summary

Like everything in life, the issue of stock buybacks is not necessarily clear-cut. If done correctly, they can be a useful tool for management teams, benefitting companies, and shareholders alike. Misused, they can slowly destroy a company’s competitive position by focusing on short-term gratification over long-term strategic planning. I may be missing something, but I have not yet seen overwhelming evidence of the latter, so I wonder if this is a solution in search of a problem.

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Please remember that past performance may not be indicative of future results. Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.

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