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How to Make the Most of Share Buybacks

By Chad Fraser on January 2, 2013

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U.S. companies are sitting on more cash than ever. According to JP Morgan, the S&P 500’s combined cash holdings rose 14% through the first nine months of 2012, to $1.5 trillion. That’s because the uncertain global economy is prompting companies to hang onto cash instead of spending on expansion, for example, or hiring new employees.

Instead, many are returning cash to their shareholders, often through share buybacks. According to Yardeni Research, U.S. companies repurchased $274 billion more shares than they issued through the first three quarters of the year. Examples include General Electric (NYSE: GE), which recently said it would buy back $10 billion of its stock through 2015. That’s in addition to the $4.9 billion remaining on its current repurchase authorization.

Home Depot (NYSE: HD) has also spent $3.3 billion on share buybacks over the first three quarters of its current fiscal year, and plans to spend an additional $700 million in the current quarter, to bring the total to $4 billion.

International Business Machines (NYSE: IBM) continues to be a leader in share buybacks: the company plans to repurchase $50 billion of its stock in the five years to 2015. Interestingly, IBM is leaning more on share buybacks than the other way companies typically reward their shareholders: through dividends. Big Blue plans to spend $20 billion on its regular quarterly payout in the same period.

How Share Buybacks Work

Under a share buyback, a company purchases a certain number of its own shares. It may do this on the open market or by giving its shareholders the option to tender their stock to the company, usually at a slight premium to the market price. The company then either cancels the purchased shares or holds on to them as “treasury stock” for possible reissuance. Either way, the stock repurchase reduces the total number of shares outstanding and gives each shareholder a larger economic slice of the company.

Buybacks also increase earnings per share (because total earnings are divided by fewer shares) and tend to increase the market value of the remaining shares — although academics argue that intrinsic value does not actually increase.

There is an ongoing debate over which form of investor reward is better: dividends or buybacks. Back in 2010, Investing Daily’s Jim Fink sampled the opinions of three Investing Daily editors, all of whom came down rather strongly on the side of dividends. But they also pointed out some aspects of buybacks that make them attractive, especially in uncertain economies like today’s.

Four Things to Keep in Mind When Assessing Share Buybacks

  • Share buybacks let you defer taxes because you aren’t taxed on your gains until you sell your shares, while dividends are taxed in the year you receive them. This could make buybacks more attractive to some investors in light of yesterday’s fiscal cliff deal, which would raise taxes on both dividends and capital gains to 20% from 15% for individuals making more than $400,000 and couples who earn more than $450,000. Tack on an additional 3.8% surtax for health care reform, and that total rises to 23.8%.
    • Share buybacks give management flexibility: Many investors view dividends as a promise, and any cut is likely to send them scurrying for the exits.Holding off on buybacks, however, isn’t liable to affect most investors’ view of the stock. IBM, for example, is under no obligation to stick to its share buyback pledge. Many companies, in fact, never use all the funds their boards authorize for repurchases. This flexibility can be a plus if a company holds off on buybacks to pursue a new opportunity with strong potential, say, or make an acquisition that will boost its profits.
      • Timing has a huge impact on share buybacks’ effectiveness: A frequent criticism of buybacks is that management often repurchases shares when they are overpriced. An obvious example of this occurred in the third quarter of 2007, when S&P 500 companies spent a record $172 billion on buybacks with the market near an all-time high. Spending on repurchases then plunged more than 85 per cent, to $24 billion, by the second quarter of 2009. During that period, the S&P 500 Index fell by about 47 per cent, so companies had repurchased more shares when they were expensive and fewer when they were cheap.
      • Look out for companies that use buybacks to offset stock-based compensation. This dilutes the effect of the buyback, because the shares the company is taking off the market are simply replaced by the ones it issues to management.

      For Jim Fink, the question of whether buybacks are better than dividends comes down to your view of a company’s management. “Bottom line,” he wrote in his 2010 article, “for total return investors, dividends are better if you don’t trust corporate management, and buybacks are better if you trust corporate management … The safe thing is to invest in companies with good management, but require at least a small dividend anyway. Trust but verify.”

      What do you think of this article? Please post your feedback in the “comments” section below!

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      1. avatar
        ralph spano Reply January 5, 2013 at 6:48 PM EDT

        I found this article very informative, and always look forward to reading all the articles written in Investor Daily.

      2. avatar
        Steve Reply January 5, 2013 at 8:35 AM EDT

        I think share buybacks are basically a scam – officers want to raise share prices so they can increase their compensation and stock options, while stiffing the owners.