Companies are dipping into record hoards of cash these days to buy back their own stock. But in a lot of cases, investors may not be getting value for their money.
Many repurchases are little more than disguised stock-based compensation for employees and directors. Corporate treasuries buy back millions of shares, but rather than retire them, they hand the shares out to insiders at deeply discounted rates, frequently in the form of stock options.
The problem is that many buyback announcements are lumped with dividend payout announcements and framed as moves to return capital to shareholders.
“Buyback announcements should always be questioned and can be red flags,” says Mark Rosen, director of research at Accountability Research Corp. in Toronto.
The best type of buyback is the one meant to signal to the market that a stock is undervalued. Apple Inc. may have been doing just that this week when it announced plans to spend up to $60-billion (U.S.) by the end of 2015 on buybacks. The initiative represents the largest share repurchase authorization ever made by a board of directors.
If Apple follows through on its stated intentions, the company will reduce its share count by 15 per cent over the next few years, Mr. Rosen says.
A decrease in outstanding shares benefits investors by increasing earnings per share, reducing the stock’s price-to-earnings ratio and boosting both the return on equity and return on assets (by removing idle cash from the balance sheet). In fact, many investors look more favourably on share buybacks than dividends because cash payouts are taxable, while concentrating the value of the company into fewer shares carries no tax consequences.
Unfortunately, the trend today among companies is to use buybacks mainly to control the dilution of their share base as they hand out more stocks and options to insiders.
In the fourth quarter of last year, 317 of the S&P 500 companies spent close to $100-billion to repurchase shares. Of that number, 203 of the companies actually saw their outstanding share counts rise, says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices LLC.
“Companies continued to protect their earnings from dilution due to option execution and issuance during the fourth quarter of 2012,” Mr. Silverblatt notes. “Most companies, however, have not taken the more aggressive action seen in 2006 and 2007 when buying extra shares to reduce share count was a major tool used to increase their earnings per share.”
The precursor to Apple’s latest buyback was a $10-billion share repurchase program over three years, announced in 2012. To its credit, Apple made clear the objective was to neutralize “the impact of dilution from future employee equity grants and employee stock purchase programs.”
Mr. Rosen estimates that prior to the buyback program, Apple’s share count had traditionally increased by between 1 and 2 per cent annually because of compensation.
Industrial firms, including General Electric, merchants such as Wal-Mart, and media giants like Time Warner have all been active buyers of their own shares in the last year. But the information technology sector continues to lead all others in buybacks. The repurchases have lifted earnings-per-share among the tech giants, but they have also amounted to a significant payday to insiders – one with no direct benefit to shareholders.
Microsoft Corp., for example, spent $105.1-billion between 2004 and last year buying back 3.8 billion of its own shares. During the same period, however, the number of outstanding Microsoft shares decreased by only 2.5 billion. Almost all of the difference, or approximately $35.7-billion of the total expenditure, went to cover stock-based compensation, according to information in company filings.
In the case of Cisco Systems Inc., the company spent $76.9-billion between September, 2001, and January, 2013, to buy back 3.8 billion shares. But the number of outstanding shares declined by just over half that amount, or 2 billion shares.
It’s vital for investors to distinguish between different types of repurchase programs, says Partha Mohanram, a professor of financial accounting at the Rotman School of Management. Quarterly dividend announcements suggest maturity. But buybacks may signal any number of things, including an effort to offset stock-based compensation, a windfall of cash on the books together with a lack of investment opportunities, or a discounted valuation, he said.