Why Do Companies Buy Back Their Stock?
A blog by Frederic P. Slade, CFA, Assistant Vice President, Senior Director of Investments, Pentegra Retirement Services – July 21, 2015
A financial headline reading something like, “Company X repurchased 50 million shares of its stock” has become a common one in recent years. According to Factset1, companies in the S&P 500 Index spent $564.7 billion on share repurchases in 2014, an 18% increase over the prior year. Apple Inc. alone spent $57 billion during the past year. These buybacks have helped fuel rallies in Apple (+40.6% return in 2014) and the overall market (an S&P 500 Index return of +13.7% in 2014).
Why do corporations buy back their stock? When companies have excess cash (through retained earnings or borrowing), they have several options: (a) repurchasing their stock, thereby reducing the outstanding shares held by the public; (b) using the cash to provide shareholders with dividends or one-time payments; (c) reinvesting the cash in their operations and capital expenditures; and (d) using the cash to pay down their outstanding debt.
A company may believe that by buying back its shares and consequently increasing its market value and improving its financial ratios (such as earnings per share), it is providing the greatest return to its shareholders, relative to other uses. A company may also feel it must respond to pressure from outside investors who believe that the company is undervalued.
What are the potential downside issues associated with stock buybacks? First, the company may be sacrificing long term growth by delaying reinvestment in its business. Second, if a company is using borrowed funds to pay for the repurchases, it will often be viewed unfavorably by bond ratings analysts, who may downgrade the company’s debt or put it on watch due to concerns about leverage. Third, buybacks may in fact be compensating for large issuances of shares for stock option programs.
There are both pro and con arguments regarding stock repurchases. Though repurchases have helped buoy the equity markets, there is an open question: are there more productive ways for corporations to spend cash from a long-term economic growth perspective?
1. FactSet Buyback Quarterly, March 16, 2015.
NOTE: Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Past performance is not a guarantee of future results.
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