The Truth About Stock Buybacks ? Why Buybacks ... - How to Invest

I am not afraid to say that I hate stock buybacks. Companies announce stock buybacks all the time as if they are doing the investor a huge favor by purchasing some of the outstanding shares. However, the truth is that most stock buybacks are not in your best interests as an investor and why this is the case.

Conventional Wisdom on Stock Buybacks

Many investing courses and texts teach that stock buybacks are an easy way for a company to boost earnings per share when other uses for the cash are not available. A stock buyback often results when a company is doing very well and earnings are great but they are unable to find an investment opportunity that can sustain growth.

In light of no other viable investment opportunities, a company can use a stock buyback to decrease the number of outstanding shares. By reducing the number of shares, the earnings per share will go up even if the earnings stays the same, thereby creating earnings growth even without extra revenue.

For example, let?s say a company is earning $10 million a quarter and has 10 million shares outstanding. This company then has an earnings per share of $1. If the company decides to buy 10% of their stock back, the company then all of a sudden is making $10 million a quarter on 9 million shares. This company is now making $1.11 per quarter, an increase of earnings per share of 11% with no change in revenue.

By increasing earnings per share, the shares will inevitably become more valuable, or so the story goes. While using cash to drive up earnings per share looks good on paper, it unfortunately rarely works out this way in practice. The problem is not that increasing earnings per share will not drive up stock price (it does), but rather that stock buybacks rarely result in any meaningful change in EPS.

Yes, you read that right: stock buybacks are justified by companies as a means to boost earnings per share, but stock buybacks rarely meaningfully influence earnings per share. This is why buybacks are useless to the typical investor.

Why does this happen? Here are the major problems with this approach:

Most Buyback Programs Are Too Small

One reason stock buybacks do not have a significant influence on earnings per share is because they are too small to actually to shrink the earnings per share at a meaningful level to an investor. Consider Apple?s (AAPL) recent stock buyback announcement, where the company announced they would be buying back $10 billion dollars worth of stock over a 3-year span.

This amounts to less than 2% of the company?s current market cap being purchased back over a 3 year period. This means that earnings per share might go up about 2% over three years as a result of this buyback, minus the growth they would have received by investing the money elsewhere.

You might be thinking.. why would a company buyback such a small amount of stock? Well that is because..

Most Stock Buybacks are not Meant to Raise EPS

Many companies issue these small stock buybacks with no intention of raising EPS. Instead, these shares are used as part of compensation packages for executives. Companies often buy back their stock and then give it all away to their executives and vice presidents as a way to pay management extra money. Stock buybacks are where the stocks for stock options come from in older companies that have been public for a long period of time.

There is nothing wrong with buying back some stock to reward executives who have run successful companies. For example, the $10 billion buyback on AAPL over the next few years is well-deserved as over the last 15 years they have gone from a struggling company to the largest market cap in the world at the time of this writing.

The problem is that many companies that do these buybacks are not doing as well as AAPL, using earnings to reward mediocre performers and then have the gall to announce the stock buyback as if they were demonstrating their strength and boosting earnings per share, when their plan all along was to line the pockets of management.

Of course, management cannot line their pockets unless they are actually selling the stocks they receive, which leads me to my next point:

Many Shares from Buybacks Eventually Reappear on the Market

When companies give out stocks as bonuses to executives, these executives then sell the stock in order to get money. I can?t blame them ? they are being compensated after all with the stock. This stock gets sold to a shareholder like you or I and becomes part of the general shares outstanding once again.

That?s right, companies buy back stock and give it to executives. These executives then sell the stock, putting it right back on the open market. The end result is that the total number of shares outstanding does not change after the stock buyback (at least not as much as advertised).

Long Term Stock Buybacks May Secretly Fail

Sometimes the lack of a meaningful change in earnings per share is caused by the fact that stock buybacks often are never seen to completion. This is particularly true over buybacks which are announced that are covering a multi-year period. When a company says they are planning to buy back a certain number of shares over a multi-year period, this is something you have to take with a grain of salt.

When a company announces in 2012 that they are re-buying stock in 2016, if they nix the program and stop buying the stock in 2014 when money is a little tighter, most investors will be none the wiser. It is not really newsworthy when a company stops a buyback program they announced a year or more in the past.

As a result, be careful of buying on the news of a multi-year buyback program. In fact, I would not even consider multi-year buybacks as a plus for a company. The only thing I care about that far in the future when it comes to a stock is their projected earnings and growth opportunities.

A Dividend Boost is a Much Better Service to Investors

Not only as stock buybacks often misleading, but the simplest way to create wealth for investors is to give them the money directly. If a company was during well and truly wanted to reward its shareholders, it would boost dividends.

When a company is doing well and is truly looking out for investors, they raise dividends or even give 1-time bonuses. Not only is money directly in the hands of the investor the best course of the investor, it is also the most efficient course. Companies who have the money to buy back stocks are often running on 52-week highs ? buying back a stock that has already run is a waste of capital.

Exceptions to the Rule ? Spotting a Good Buyback

Like anything in life, there are some exceptions to this rule. The best buybacks are large buybacks which are slated to be completed in the year they are announced. Buybacks that can meaningfully increase earnings per share (i..e at least 8% of the company, in my opinion).

Furthermore, I like to see either a company which has a history of following through with its buybacks (check for any failed or cancelled buyback programs in the past) or an increase in dividend in conjunction with the buyback. I cannot fault AAPL for their $10 billion buyback over 3 years because at the same time they announced their buyback, they announced a dividend program which would amount to about $10 billion annually, a much larger portion than the buyback.

You should also know that some banks are being regulated by the Government in regards to how much money they can distribute via a dividend. After the banking bailout, the Government has set guidelines on what banks can and cannot do. One thing in particular the Fed has been doing is pushing banks towards stock buybacks and away from dividends, or at least making the banks do some of each rather than allowing the banks to issue a straight dividend.

No matter what the buyback looks like, as an investor I would always prefer an increase in the dividend or even a one-time payout over a stock buyback.

If I am holding a stock that goes up after a buyback is announced, I will enjoy the run up in price, but I will not jump on a new stock after a buyback is announced as most stock buybacks really mean nothing to your bottom line. Most buyback shares are given to employees and then ultimately float their way back out onto the open market, leaving you with the same number of shares outstanding as you had before the buyback was announced.

As a general rule, do not count on most buybacks to boost the earnings per share of a company or even the net worth of your holdings in that company over the long term.

Source: http://www.howtoinvesthq.com/the-truth-about-stock-buybacks/

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