Understanding the Appeal of Share Buybacks

The amount of money devoted to corporate stock buybacks surged throughout 2010 and 2011 as large companies sought ways to spend their cash stockpiles and reward shareholders. In fact, S&P 500 stock repurchases marked eight quarterly increases in a row by the second quarter of 2011, returning to levels not seen since early 2008.¹

When a company buys back its own shares, it removes them from the marketplace, reducing the number of available shares. When earnings are divided by fewer shares, it raises the earnings-per-share results and tends to push up the market value of the remaining stock. However, the fact that so many companies are unable to find more productive ways to invest their resources suggests the practice is not always as positive for investors as it might first appear.

Here’s a closer look at what recent buyback trends could mean to investors and the national economy.

Seizing Opportunity or Business as Usual?

By mid-2011, the Federal Reserve reported that U.S. nonfinancial companies were holding cash and other liquid assets worth more than $2 trillion.² Corporations generally have four options for deploying their excess cash flow: acquire other businesses, reinvest in the company through capital expenditures (including expanding operations and hiring employees), pay out dividends, or buy back shares.

A buyback may signal that management believes the company’s stock has been underpriced by the market and that the intrinsic value of the company can be enhanced by repurchasing shares. If the stock is truly undervalued, increasing the return on equity could be a profitable course of action for the company.

Of course, there is no guarantee that a company will repurchase stock at a favorable price. A high-priced buyback, or one undertaken solely to increase earnings per share, is not likely to offer the same benefits for investors. Repurchases have also become relatively common — about 350 of the 500 corporations on the S&P 500 tend to execute buybacks on a quarterly basis.³

Looking at a single corporation’s cash position and buyback history may be helpful in some respects, but it may actually reveal little about the company’s future prospects. When evaluating potential stock investments, there are many other important factors to consider. The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.

Full Coffers, Little Confidence

Solid profits and a record amount of excess cash may begin to explain why corporations have been employing this business strategy more regularly. In addition, tepid consumer demand and worries about another possible recession may have added to the level of uncertainty and made it difficult for many businesses to commit their resources to major projects.⁴

Because a buyback is essentially a one-time event, it may represent a more flexible way to return value to shareholders when compared to other options that tend to require a longer-term financial investment.

A primary goal of publicly held firms is to protect the interests of stakeholders. Unfortunately, when businesses are not spending money to initiate new projects or hire employees, it may also restrain economic growth.

1) Standard & Poor’s, 2011
2) The Wall Street Journal, September 16, 2011
3) Reuters, September 27, 2011
4) Businessweek.com, March 31, 2010

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent Naperville Financial Planning Services advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright © 2012 Emerald Connect, Inc.

Thursday, May 31, 2012