Share Buybacks: Advantages and Disadvantages

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Since the 1980s, companies in the US have started to buy back more and more shares as a result of corporate payout policy and SEC rule changes. Nowadays, the act of repurchasing stock in excess appears to be completely normal as the biggest tech firms are spending billions of dollars each quarter on corporate buybacks.

Here is a chart listing some of the major companies and how much they’ve spent in buying back shares in the last twelve months:

After observing all those trillions of dollars that companies have been spending in the past years just to buy back shares, a reasonable question that one might ask is: are share repurchases just quick and easy acts of driving stock prices in the short term, or can companies and shareholders truly benefit from share buybacks in the long run?


Putting Excess Cash Into Good Use

First of all, let’s get to the basics of what share buybacks are and in which circumstances companies might be interested in repurchasing shares. When a company has excess cash which can’t be put into good use otherwise, it’s in the interest of the business and the owners to return those profits to the shareholders.

Returning cash to shareholders can either happen in one of the two following ways:


1. Paying a dividend

Dividends are the most straightforward way of returning profits to the owners of a business. When a company decides to pay a dividend, each shareholder receives a cash payment in proportion to their ownership stake in the business. As soon as a company starts paying dividends for the first time, investors expect the business to continue paying dividends in the future, which can build pressure on the management.

This is why many companies (especially young businesses) don’t prefer to pay out dividends. Many mature companies on the other hand, usually pay out dividends as a result of their limited growth runway in the future. Apple, for instance, has started paying dividends since 2012 once it generated so much earnings that it became more difficult for the company to grow from its bigger base.


2. Buying back stock

Share repurchases are a form of distributing cash to shareholders put differently. When a business decides to repurchase shares from the open market, only the shareholders who are willing to tender their shares get cashed out, while the ownership stake of each existing shareholder increases. Unlike dividends, investors don’t expect businesses to repurchase shares continuously into the future once they start. Therefore, companies can choose when to conduct a share buyback without being under too much pressure by expectations.

In theory, dividend payments and share repurchases should have similar effects on the value of a business because in both cases, the value is either being distributed to all existing shareholders or transferred from shareholders who are willing to sell to the remaining shareholders. However, in practical terms, there are inherent differences between those two options because of the consequences that come with them. 

The result is that share repurchases can either have positive outcomes for the owners of the business or negative consequences depending on the business itself and the initial conditions with which a share buyback was conducted.


Advantages of Share Buybacks


Avoiding Poor Investment Decisions

Making the proper investment choices to grow a business can be difficult and requires capital which can either be raised through equity or debt. Investors and lenders demand a certain return for them to provide funds, and if a business doesn’t manage to gain a high enough return on its investments, it is essentially destroying shareholder value. In that case, buying back stock as a form of returning profits can be a proper way of making meaningful use of excess cash and can save shareholders lots of headaches.

A great cash balance can have a value-destroying effect on a company when it uses the cash to make investment choices that are unlucrative in comparison to the cost to raise capital.

Companies with a track record of making poor investment decisions (return on invested capital being lower than the cost of capital) shouldn’t use any excess cash balance to fund further investments. Investors would expect the company to distribute that cash to shareholders instead. In that case, share buybacks would represent a purposeful use to all owners within the business.

So when do companies make poor investment decisions and how can that be determined? One approach to assessing whether a company is making good or bad investments is to calculate the return of invested capital (ROIC) and then to put that into perspective with the cost of capital (WACC) of the business. If the ROIC of a business is less than its cost of raising capital, it is considered inefficient and essentially destroying shareholder value.


Taking Advantage of Undervaluation

A good incentive for a company’s management to conduct a share buyback would be when those shares are trading at an undervalued price. When a company buys back shares that are undervalued, all shareholders who are willing to sell their shares will seize their undervalued shares to the business, while the remaining shareholders will profit from gaining more stake in an undervalued business.

If the stock is truly undervalued, all the remaining shareholders should be able to benefit from those share repurchases in the future.

All these effects depend on the premise that management can accurately assess the value of their company and act accordingly to the occasion of undervaluation. However, history has shown that companies conduct share repurchases even in late bull markets when the market peaks which indicates that many companies don’t necessarily act on undervaluation.


Showing Positive Signals to Investors

Shortly after a business announces to buy back shares, the stock price of that company often increases as a result of what investors interpret as the action made by the company. As soon as a company announces a share buyback, it signals that the management is confident about the future prospects of the business and that they may have the opportunity now to buy back stock at an undervalued price.

However, this action presupposes that the management of a company is competent enough to assess the positive factors which could lead to an increase in shareholder value and honest about the signalizing effect it sends to investors. Since most corporate executives are compensated in stock, there are some formidable incentives for a company’s management to buy back shares even if that may not be a proper decision for a company’s long-term prospects but rather to boost up share prices.


Disadvantages of Share Buybacks


Missing out on Investment Opportunities

Reinvesting money back into a business can either be a good or bad choice. Logically, poor investments earn a lower return than what they initially cost and should therefore be avoided. That being said, for many young companies, making use of all available capital will be necessary to grow substantially while they still can. But there are also examples of companies out there that simply repurchase shares intending to boost share prices, without considering reinvestments that could have earned the necessary return for the business to grow. In that regard, share buybacks could affect shareholders adversely in the long term.


Overlevering the business with Debt

Repurchasing shares requires capital. Since it wouldn’t make much sense to issue additional shares (equity financing) to repurchase shares, many companies take on additional debt to fund their share buybacks. Debt doesn’t necessarily have to be bad on its own and affect a company negatively but in many cases, it does because of the amount of debt that a business is already levered with.

Any type of debt creates a contractual commitment for a business to pay off that debt in the future which means that it needs to rely on its future performance and financial health. If a company isn’t able to pay off the amount of debt that is due, it will need to file for bankruptcy. 

Younger companies shouldn’t be able to afford any debt while they’re still small because of the considerable amount of risk they already face. The same goes for mature businesses that are already highly levered. Therefore, any share buyback which is financed fully or partly with debt can pull some companies into serious trouble, depending on their financial health conditions.


Falling for Overvaluation

If a company can accomplish buying back undervalued shares by which all existing shareholders who are not willing to sell, will benefit from getting more ownership for a discount, the opposite scenario can also take place.

In the case in which a company buys back shares at a price that is above its value, shareholders who are selling their shares would get rid of overvalued ownership while the ones not willing to sell would “lose” value from having to take on more overvalued holdings. The reality looks to be that most firms don’t really seem to care about price during a share buyback. The huge rally of corporate buybacks doesn’t appear to end anytime soon, which indicates that a company is more likely to buy back shares when they’re overvalued instead of when it would be best suited.


Conclusion

Assessing whether the positive effects of a share buyback outweigh the negative ones, can be difficult since share buybacks can really be a double-edged sword to the value of a company. If a firm that is already considered risky, initiates a share buyback that is fully financed with debt, it can adversely affect the business because of higher bankruptcy risk. Share buybacks can also turn out to be poor decisions when the cash which was used in the share buyback could have been reinvested into the operating businesses instead, to achieve higher returns.

As an example, a great case scenario in which a company would repurchase shares is when the company isn’t over-levered with debt, can’t put excess cash into other investments that bring in a high enough return, and manages to acquire shares at a price which is below value. On the other hand, a bad case for conducting a share buyback would be, when highly leveraged business funds a share buyback with debt to repurchase shares at an overvalued price, while it could have created excess returns with reinvestments in the first place.

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