Stock Buybacks Aren’t Bad, Just Misused & Abused

I remember in the late 90’s and early 2000’s that I would get regular phone calls and emails asking me about a widely owned equity. The conversation almost always went like this:

“Now that XYZ company is trading at $XX/share do you think they will split the stock soon? They have often done so in the past whenever the price reached this level.”

It was a valid question as companies way back then often split shares for to increase share counts for mergers and acquisitions, lower the price for market participation, and for executive compensation plans.

However, following the financial crisis stock splits disappeared and a new trend emerged – share repurchases. Like stock splits, share repurchases in and of themselves are not necessarily a bad thing, it is just the least best use of cash. Instead of using cash to expand production, increase sales, acquire competitors, or buy into new products or services, the cash is used to simply reduce outstanding share count by removing some shareholders from the pool. Here is a simple example:

  • Company A earns $1 / share and there are 10 / shares outstanding. 
  • Earnings Per Share (EPS) = $0.10/share.
  • Company A uses all of its cash to buy back 5 shares of stock.
  • Next year, Company A earns $0.20/share ($1 / 5 shares)
  • Stock price rises because EPS jumped by 100%.
  • However, since the company used all of its cash to buy back the shares, they had nothing left to grow their business.
  • The next year Company A still earns $1/share and EPS remains at $0.20/share.
  • Stock price falls because of 0% growth over the year. 

This is a bit of an extreme example but shows the point that share repurchases have a very limited, one-time effect, on the company. This is why once a company engages in share repurchases they are inevitably trapped into continuing to repurchase shares to keep asset prices elevated. This diverts the ever-increasing amount of cash from more productive investments.

As shown in the chart below, the share count of public corporations has dropped sharply over the last decade as companies scramble to shore up bottom line earnings to beat Wall Street estimates against a backdrop of a slowly growing economy and sales.

(The chart below shows the differential added per share via stock backs. It also shows the cumulative growth in EPS and Revenue/Share since 2011)

(Click on image to enlarge)

The Abuse & Misuse 

As I stated, share repurchases aren’t necessarily a bad thing. It is just the misuse and abuse of them which becomes problematic. It’s not just share repurchases though. In “4-Tools To Beat The Wall Street Estimate Game” we discussed how companies not only use stock repurchases, but a variety of other accounting gimmicks to “meet their numbers.” 

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