Share Buyback - The Price Needs To Be Right
There are two ways which companies return profits to shareholders. The first is by paying dividends and the second is by buying back shares of their own stock. Increasingly more and more companies are focusing on share buybacks instead of dividends, as the dividend yield for the S&P 500 sits at just 2% today, well below its historical average.
S&P 500 Historical Dividend Yield
Dividends used to be the main reason for investors to own stocks. The times have clearly changed. Image from: multpl.com
Before the financial crisis of 2008-2009 companies spent record amounts on share buybacks. In 2007 the companies making up the S&P 500 spent a total of $589 billion on share buybacks compared to just $247 billion on dividends. Then, in the heart of the financial crisis when equity prices were at historic lows, companies severely cut back on share buybacks, spending just $138 billion in 2009. Now that the market has largely recovered companies have increased share buybacks, with about $111 billion in the second quarter of 2012 alone.
Share buyback data from Yahoo Finance
Are share buybacks beneficial to shareholders? The answer is - it depends. Let's do a simple numerical experiment to see the effects of share buybacks.
Timing Is Of The Essence
Imagine a fictional company - let's call it XYZ - which had 200 million outstanding shares on Oct 23, 2009. On that date the company announced a share repurchase program allowing for the repurchase of $1 billion of stock over the next three years. Here's what the stock does between that time and now.
XYZ Stock Price
Let's see what happens under two different scenarios:
- The CEO aggressively buys back stock, spending $500 million buying back shares over the first year of the program at an average cost of $37 per share. After the stock drops in the beginning of 2011 the CEO slows down repurchases a bit, spending the remaining $500 million over the next two years at an average cost of $26 per share, not buying any after the steep drop in early 2012. In this scenario the company spent a total of $1 billion to buy back 32.74 million shares, reducing the company's float to 167.26 million shares.
- The CEO refuses to buy back shares when he feels that the stock is overpriced. In the first year he only buys shares after the stock has slumped, spending $100 million at an average cost of $34 per share. Once the stock drops at the beginning of 2011 the CEO spends the remaining share buyback money in three periods: $200 million at $29 per share in the first half of 2011, $200 million at $25 per share in the second half of 2011 and the first half of 2012, and $500 million at $19 per share in the second half of 2012. In this scenario the company spent a total of $1 billion to buy back 44.15 million shares, reducing the company's float to 155.85 million shares.
What happens to the average shareholder during these two scenarios? If you owned 1000 shares of XYZ before the share buyback program you owned 0.0005% of the company. After scenario 1 those same shares now represent 0.00059787% of the company, a 19.57% increase. After scenario 2 those shares represent 0.00064164% of the company, a full 28.33% increase.
In each scenario the company spent the same $1 billion, but in scenario 2 the shareholder ends up owning a significantly larger percentage of the company. This is because the CEO in the second scenario only bought shares at low prices while the CEO in the second scenario over-payed for many of his repurchased shares.
The Bottom Line
Unfortunately, share buybacks usually occur according to the first scenario. Companies often try to push their own stock price up by buying back shares only to drastically overpay and do a real disservice to the shareholder. When a company buys shares of its own stock the message it sends is "Our own stock is the best investment that we can make." Too many companies have been woefully wrong, and a dividend payment would have given much greater benefit to the shareholder. Warren Buffett, in his 2000 letter to shareholders, said of share buybacks:
There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds - cash plus sensible borrowing capacity - beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down. It appears to us that many companies now making repurchases are overpaying departing shareholders at the expense of those who stay. In defense of those companies, I would say that it is natural for CEOs to be optimistic about their own businesses. They also know a whole lot more about them than I do. However, I can't help but feel that too often today's repurchases are dictated by management's desire to show confidence' or be in fashion rather than by a desire to enhance per-share value. Warren Buffett
Stock buybacks are not inherently bad. However, repurchases which occur at high prices do more harm to shareholders than they do good. More often than not it would be advisable for the company to simply pay out a bigger dividend instead of repurchasing shares. Unfortunately, most companies don't seem to care.
(The stock chart used is actually Best Buy stock. Best Buy is a perfect example of a company which spent huge sums of money on overpriced shares only to suspend the share buyback program when their stock price fell.)
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