Now is probably a good time to explain stock buy-back plans since they have recently outpaced dividends as the greater “rewards program” for stock investors. Last year’s total payouts in dividends and buybacks was over one trillion dollars --- the highest amount in history.
Basically, there are just three ways that companies create value for their investors. First, they can share profits by paying out a portion of what they earn as dividends and then reinvesting what is left. Next, they can keep all their profits like Warren Buffett does at Berkshire Hathaway and give the company the greatest opportunity to benefit investors by creating capital gains. The Oracle of Omaha believes that anyone investing in his company should assume that he (Mr. Buffett) can invest more productively than his investors. Why should he distribute profits for people to invest elsewhere when they have clearly signaled that they want him to invest those profits? Well over half of all public companies pay no dividends and just reinvest their profits.
Then, there are share buybacks. This is the situation where a company spends its accumulated cash, or even borrows money in some cases, to buy back stock at a price that will induce some investors to sell. The value of the company remains the same. The number of outstanding shares that owns that value is now smaller, so the value per share has just been increased. In simple terms, if two people own equal shares of a company, and one is talked into selling his or her share, the remaining share holder owns 100 percent. The value of what was fifty percent has just doubled --- a 100 percent capital gain.
Last year, American companies flush with cash after the most profitable year in history, were prompted to buy back over $500 billion of their own stock. The theory is that this will increase the value of the remaining shares as the original value of the company is spread out over a smaller number of shareholders. The increase in value, unlike a paid dividend, is not taxed until the investor sells all or a portion of the shares. At that point, it will be taxed as capital gains.
Company management, not surprisingly, is often in favor of share buybacks because executives are partly compensated by stock options which only become valuable when their company share prices rise above a strike price of the option. These mandarins of corporate America whose CEO’s are now, in some cases paid over 500 times the median salary of rank and file employees, gain far more from a rise in stock price than from the payment of a dividend. When confronting the choice as to what to do with profits, managers can easily rationalize what is in their self-interest.
So are buybacks good for investors? It depends. The cash hoard partially spent on the purchase may have contributed to investors’ perception of the company’s value in the first place. Paying it out to retire outstanding stock may result in a decline in value, so the exercise was “revenue neutral.” A company that borrows money to retire stock just puts itself closer to the risk of insolvency if business turns sour. Stock prices will drop to reflect this.
On the other hand, a company management that offers a buyback is signaling that these insiders think the stock is underpriced relative to the company’s intrinsic value. Buying the cheap stock is a better investment than investing the profits to expand the company or explore new markets. Moreover, while dividends tend to be locked in as so many cents per share with investors depending upon them for income, stock buybacks are episodic. They happen occasionally and tend to be one-time events
The argument pro and con regarding buybacks amounts to draw. Hewlett Packard has paid out $60 billion to stockholders and Microsoft over $100 billion. Many would argue that this was an improvement over what have been failed efforts to buy successful companies or develop new products. Exxon has paid out over $220 billion for buybacks over the past ten years. This may mean that “Big Oil” is foreseeing what for them may be twilight in the desert. For mature companies like these just mentioned, buybacks offer investors the opportunity to take the money and run.