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Why Stock Buybacks Are So Popular Now

There's few safer ways for companies to burn that excess cash

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Recently, Standard & Poor’s announced that stock buybacks by S&P 500 companies increased 8.4% in the third quarter from a quarter ago to $118 billion. That’s an astounding 49% jump from the same period last year and the ninth consecutive quarter of growth in repurchases.

So why are companies buying back their shares at a record pace? Well, there are a few different camps of thought on this:

Although the primary goal of every publicly traded company should be to maximize shareholder value, I think we all know that happens only in a vacuum.

We can debate whether current executive pay levels and bonus structures encourage or become detrimental to this objective. But one thing we do know is that many factors go into management decisions about what to do with excess cash that sits on the balance sheet.

Remember, company share repurchase programs reduce the number of outstanding shares, which means each existing share you own now represents a larger percentage of equity in the company. That fits the very definition of increasing shareholder value — but not all firms believe it maximizes that value, and thus is not necessarily the best use of cash.

For instance, Apple (NASDAQ:AAPL) long has been notorious for simply sitting on mounds of cash — currently almost $26 billion of it. However, few investors would accuse Apple of not maximizing shareholder value during the past decade — after all, a 3,700% return tends to outweigh a little extra cash lying around.

Whether you agree, Apple always has been one to march to the beat of a different drummer. Laurie Hodrick, a economics professor at Columbia University, said this summer that one of the reasons U.S. companies were amassing so much cash was it provided them with financial flexibility in times of heightened economic uncertainty.

An optimist might infer that a willingness by firms to start putting that cash to work points to an improving economy in their eyes.

Money Speaks Louder Than Words

Sentiment surveys are nice water cooler fodder, but money talks, so moving cash off the balance sheet could be one of the most telling statements of what America’s CEOs think of the near-term outlook for the economy.

I think the primary reason we’ve seen so much share buyback activity is because firms believe their shares are severely undervalued. A company buying back its shares is investing in itself the same way any investor would. Buy low and sell high, right?

If they can buy shares at what feels like depressed values, then perhaps reissue those shares at a later date when the value is at a more appropriate level, then management is accomplishing the same goal we set out to. Of course, management must think the internal rate of return it can achieve on these share buybacks must exceed the returns it can get on other investment options — otherwise it becomes, for lack of a better term, financially irresponsible.

Of course, now we’re back in the vacuum.

But there’s no question that the public perception of a company that’s gobbling up its own shares is positive. It demonstrates confidence in the business — and encourages investors to think in kind.

Article printed from InvestorPlace Media,

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