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Everything You Need to Know About Stock Buybacks

Here’s a look a comprehensive look at the mechanics as well as the pros and cons

If you take a look at Wikipedia (a dangerous habit at times), you’ll discover the straightforward definition of a stock buyback, or share repurchase: “the re-acquisition by a company of its own stock.”

Everything You Need to Know About Stock Buybacks
Source: Shutterstock

Or consider what Eugene Fama, Professor of Finance at Chicago Booth, has said about the topic in an email interview with InvestorPlace.com: “Buybacks are just an alternative to dividends. They are never a source of worry.”

Yes, it’s all fairly simple, right? At a high level, this is true. But keep in mind that there are lots of nuances and implications to buying back stock. Let’s take a deeper look at how share repurchases function within the grander picture.

History of Stock Buybacks

Until 1982, buying back shares was rare. Companies were fearful of violating securities laws. After all, the executives may be tempted to use their insider knowledge to time purchases and manipulate the markets. Yet the Securities and Exchange Commission wanted to find ways to ease the restrictions. To this end, there were several safe harbors put in place for stock buybacks.

The timing of this regulatory change was not coincidental. It was at the dawn of the Reagan Administration, which was spearheading wide-scale deregulation throughout the U.S. economy.

There was also the support from academia, especially Harvard Business School’s Michael Jensen. In 1982, he wrote his influential research paper “Reflections on the Corporation as a Social Invention.” His main contention was that a company’s sole responsibility was for enhancing shareholder value. It was not to serve its various stakeholders like employees, customers and so on.

Interestingly enough, the liberalization of buybacks initially had mostly an impact on hostile takeovers. Fueled by Mike Milken’s junk bond franchise, Corporate America was looking for ways to fend off raiders. Often this would include stock buybacks (which became known as “greenmail”) or even going private transactions.

However, when the takeover era ended by the late 1980s, there emerged a new trend. Executives looked to stock buybacks as a strategy to help boost the stock price.

The Mechanics of Share Repurchases

The board of directors authorizes a buyback, which is usually announced via a press release or in an earnings report. But it is up to the discretion of senior management for the timing of the purchases. In fact, in some cases, they may not even reach the amount that was initially authorized.

Most stock buybacks are done through open market purchases. But companies will usually not make any purchases during the black out period (this is a set time around an earnings report). There is also SEC Rule 10b-18 that prevents a company from acquiring up to 25% of the daily volume. Other then these factors, there are few restrictions.

In some cases, a company may hire an investment banker to handle more sophisticated transactions. One is an accelerated share repurchase or ASR. With this, the company will buy its shares from a Wall Street firm, like Goldman Sachs (NYSE:GS) or Morgan Stanley (NYSE:MS), which has borrowed them from existing shareholders. This process can range anywhere from a day to a couple of months.

In other cases, a company may buy its shares via a tender offer, which involves a fixed price for certain number of shares. Tender offers have a time limit and requires an SEC filing. For the most part, it can be an efficient way to make a large purchase.

Then there is the Dutch auction, which is another type of tender offer. But this includes a price range that the shares will be purchased. By doing this, the lowest price is selected based on the supply and demand.

Regardless of the approach, a company has the discretion as to how to handle the shares repurchased. That is, they can either be retired or kept in the treasury, which can then be resold in the future.

How Big?

Stock buybacks have become a very big business on Wall Street. According to research from Goldman Sachs, the volume was about $3.8 trillion in purchases during the past nine years, which was bigger than the buying power of every other type of investor combined. Interestingly in a recent note from the firm, there could actually be lower gains in 2020 if the buyback activity declines.

Although, regarding the latest data, there are no signs of a precipitous decline. Take a look at the third-quarter report from the S&P Dow Jones Indices. The stock buybacks rose 6.3% to $175.9 billion on a quarter-over-quarter basis.

Although, the volume is lumpy. Consider that 20 companies represented about half of all the purchase volume during the quarter. As should be no surprise, the biggest spender was Apple (NASDAQ:AAPL) at $17.6 billion. Some of the others included Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC), JPMorgan (NYSE:JPM) and Alphabet (NASDAQ:GOOGL, NASDAQ:GOOG).

The Main Reasons for Repurchases

Legendary investor Warren Buffett is not a fan of dividends. He says that if an investor needs income he or she can just sell some stock.

However, Buffett really does like stock buybacks, so long as the valuation is attractive. For example, here’s what he said about the topic regarding Apple while at the 2018 shareholders meeting:

“I’m delighted to see them repurchasing shares … You can say we own 5% of it. But I figure with, you know, with the passage of a little time we may own 6% or 7% simply because they repurchase shares … I find that if you’ve got an extraordinary product, and ecosystem, and there’s lots to be done, I love the idea of having our 5%, or whatever it may be, grow to 6% or 7% without us laying out a dime. I mean, it’s worked for us in many other situations.”

But of course, there are different valuation approaches, depending on the business and industry. Besides, many executives have various viewpoints on the benefits of stock buybacks.

Here’s a look:

Financial Engineering: A buyback can make key financial metrics look better, such as the EPS (Earnings Per Share) figure. Let’s take an example. ABC Corp has 100 million shares outstanding and posted a profit of $90 million. Thus, the EPS is 90 cents a share (or $90 million divided by 100 million shares). To juice this up, ABC buys back 10 million shares. The result: the EPS is now at a more attractive $1 per share! By doing this, there was a 11% growth in profits without much effort. What’s more, this move will have a positive impact on other ratios, such as the debt-to-equity ratio.

Growth Opportunities: Often its mature companies that have the biggest stock buybacks. And this makes a lot of sense. All in all, they have reached a stage where it is tough to grow revenues but the cash flows remains strong. Granted, management may look at acquisitions, but this can be risky and expensive. So why not just reward shareholders with a buyback?

Better Than Dividends: It’s nice to receive a quarterly cash payment from a stock. But this can be a burden for the company. What if the economy falters and cash flows plunge? What if the core business faces a potential disruption from a new technology? In these circumstances, a company may have little choice but to reduce or eliminate the dividend. When this happens, there is usually a notable drop in the stock price. However, with a stock buyback, there is often little penalty for slowing it down or even ending it.

Employee Stock Options: Providing equity to employees can be a great motivator. But it also can lead to dilution. As a result, a company can use a stock buyback as a way to mute the impact.

The Drawbacks

Stock buybacks are far from perfect. Interestingly enough, they may ultimately have little impact on the stock price.

A stark example of this is Oracle (NASDAQ:ORCL). Since fiscal 2016, the company has repurchased a whopping $75 billion of its shares, which involved heavy borrowings. Note that the net cash balance for the company is currently a negative $17 billion.

Despite all this, Oracle stock has still underperformed and several of the bond rating agencies have downgraded the debt. Then again, the fact is that the company has struggled to compete against numerous fast-growing cloud competitors.

“When it comes to buybacks, shareholders need to ask if they are merely to prop up the financial ratios or a falling share price,” said Anthony Denier, who is the CEO of Webull, in an email interview with InvestorPlace.com. “And finally, are buybacks the best use of the company’s cash, which can be reinvested into the company to help it grow or used for mergers.”

Another nagging issue with buybacks is that the timing can be way off, resulting in significant losses for the company. This has been the case with General Electric (NYSE:GE) from 2015 to 2018, in which it repurchased $50 billion of its shares. But it was an absolute disaster. During this period, the GE stock price has gone from $30 to $11. There was also a slashing of the dividend and the company was de-listed from the Dow Jones Industrial Average.

Bottom Line

In the past few years, the topic of stock buybacks has swirled with controversy. Politicians like Bernie Sanders and Elizabeth Warren have railed against them. The belief is that buybacks are just a way for executives to line their pockets at the expense of the rest of the employees. There is also concern that these transactions result in fewer resources for R&D and capital investments. And with the upcoming Presidential election, it seems like a good bet that the rhetoric will get more intense.

But on the other hand, stock buybacks have clear advantages. They help boost returns for pensions and 401(k)s. They also allow for money to flow into the economy to be used for other purpose, such as for consumer purchases or investments in more attractive growth categories. “There is nothing sinister about buybacks,” said Robert R. Johnson, who is the Professor of Finance at Heider College of Business, Creighton University. “Limiting the ability of firm managements to deploy capital in the manner they see fit would set a dangerous precedent.”

Tom Taulli is the author of the book, Artificial Intelligence Basics: A Non-Technical IntroductionFollow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/stock-buyback-everything-to-know/.

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