Four reasons to be wary of share buybacks

Companies often spin share buybacks' as being good news for shareholders. In 2012's second quarter, S&P 500 companies spent about $112bn on such schemes. But as Joshua M Brown notes on Thereformedbroker.com, it's not good at all that firms prefer financial engineering over hiring, expansion, mergers and acquisitions, or paying out dividends. Indeed, "nothing could be less productive".

What are buybacks, and why do firms do them?

There are three key reasons given for doing buybacks. One is that a buyback is an easy way to boost earnings per share (EPS). This is a key measure of share performance, which also features in some employee remuneration schemes.

Here's how it works. Take a firm that earns £100m one year, then £100m the next. So earnings don't grow at all. The company has 200 million shares in issue. So after the first year, EPS comes in at 50p (£100m/200m). The firm then uses some of its cash pile to buy back 50 million shares. This has no impact on earnings, because the firm pays existing shareholders to give up their shares, which are then either cancelled or held in Treasury' to be reissued in future. Either way, the buyback hits net assets (the cash on the balance sheet falls), not profit.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

So in this example, the EPS figure has shot up to about 67p (£100m/150m since earnings have not changed but shares outstanding have been reduced from 200 million to 150 million). It's a neat trick surplus cash is returned to shareholders while the firm gets an instant EPS boost.

The second advantage is that, if shares are bought back using borrowed funds, this may decrease a firm's overall cost of capital. Shareholders are a relatively expensive way to fund a company because they demand compensation for the added risk they bear relative to bondholders (owners of the firm's tradeable debt).

This risk comes in two main forms. Firstly, dividends on shares are only discretionary and paid after non-discretionary interest on debt. Secondly, shares rank lower for repayment of capital than debt should a firm go bust. So let's say a firm can borrow by issuing debt with an annual yield of 4% and use it to buy back shares that cost it 8% to service. It will save itself the difference (4%) in terms of its overall financing cost.

The third benefit of a buyback is that it can boost the share price, at least short-term. In the 12 months to the start of October, for example, the share price of UK companies that did buybacks rose by an average of 20.1% against a 15.6% return for the FTSE 350, according to analysts at Shore Capital. So surely that's three reasons to like firms that buy back their shares?

What are the drawbacks?

Not so fast. As Brown argues, it's not hard to understand why the director of a cash-rich corporation might find it easy to prioritise and justify short-term profit boosting in the form of a share buyback. But that doesn't mean it's good for shareholders. While a buyback can indeed boost the share price short term via a boost to EPS, the directors probably don't have you, the shareholder, in mind when they do it. They're probably thinking of their own pay packets. Sometimes, for example, a board might issue shares or share options as part of a remuneration agreement, then use a share buyback to boost the share price simply to counter any dilutive effect on overall EPS.

Also, as Martin Hutchison points out on Marketoracle.com, many shareholders miss the hit taken by a firm's net asset value (NAV) per share when buybacks are launched. Take Apple, which has announced a $10bn buyback programme over three years.

Since Apple will be paying "several times book value" for the shares (which trade on over six times its balance sheet or 'book' value), the required cash will dilute its book value per share. In other words a share buyback may boost EPS short term but at the expense of the balance sheet. Existing bondholders may get twitchy too if more debt has been issued to fund the buyback, because it increases the firm's gearing and their risk of not being paid back.

Besides these slightly technical arguments there's a bigger problem what does a share buyback really say about a firm? Perhaps it is running out of investment ideas. "When organic profit becomes harder to come by, you see buybacks stepped up." But there's also a conflict of interest at the heart of many buybacks. Brokers make little, if any commission, from dividend payments, but they can make money by executing buybacks for clients by contacting and 'book building' willing institutional sellers.

Lastly, companies are often poor judges of value when it comes to their own shares they often buy high. In 2007, for example, companies spent billions both in Europe and the US buying back shares at all-time high prices. And a study by Thompson Reuters in 2011 found that "surprisingly few companies were able to repurchase shares at lower prices as well as see price appreciation within the following 12 months". Specifically they found that fewer than 20% of firms in the S&P 500 that bought back shares regularly could have claimed to have "bought low".

All in all then, a better bet for small shareholders (who, to add insult to injury, are rarely invited to sell their shares to the firm as part of a buyback programme) is a dividend. That's also a cash return, but it's paid to all shareholders on a regular basis, and provides a genuine source of income. It's why I'd take a consistent dividend-paying firm over one that engages in sporadic buybacks, every time.