Share buybacks are up substantially in 2021, nearing $200 billion worth of shares purchased by nearly 300 companies. Apple, Alphabet, Facebook, and Microsoft are leading the way with $67 billion in shares purchased between them. What’s going on with these companies, and are share buybacks good for investors?
The short answer is “generally, yes.” For the most part, share buybacks tend to be a good deal for investors because they can increase their percentage ownership in the company and increase shareholder value. In our series of posts on how to evaluate the investment performance of a company, we included a post on shareholder performance, which measures how much shareholders benefit from management decisions.
Decisions that can have the most direct impact on shareholders are what the board of directors decides to do with the profits generated by the company. Shareholder-friendly companies that are good stewards of shareholder equity look for ways to improve shareholder performance, which can be done in several ways:
- Share the profits in the form of a cash dividend
- Reinvest earnings for business growth to increase future profits
- Use the capital to buy back shares
All three can impact shareholder performance positively, and some companies may utilize some combination, but share buybacks can have the most immediate impact on shareholder value.
How Do Share Buybacks Increase Shareholder Value?
Consider the example of a small business partnership owned by five partners. Each partner owns 20% of the equity in the company and receives 20% of the profits. If one of the partners decides to move on and leave the business, the other partners can step up and use the equity to buy that partner’s shares in the company. All at once, the remaining partners are now 25% equity owners, and each receives 25% of the profits.
That is, in effect, what happens when a company buys back a portion of its outstanding shares. It reduces the number of outstanding shares, increasing the shareholders’ percentage ownership and the value of remaining shares—all good.
The question is whether the share buyback is occurring for the right reasons resulting in a good deal for the company as well.
How Companies Benefit from Share Buybacks
In the case of the four partners, they, in essence, were exchanging cash for future opportunities. They made the decision that the best use of their cash was to invest in the business. If the business does well, the value of their interests will increase. It’s not much different for a company with thousands of shareholders.
Management and the board of directors of profitable companies must make decisions about how to invest their profits. Returning profits in the form of cash dividends is the more common policy adopted by companies. But now and then, maybe after a few years of accumulating even more profits, companies decide it would be in their shareholder’s interests to reduce the float and increase the value of the remaining shares.
The company benefits because its shareholders are happy, which generally translates into sustainable business growth and increasing shareholder value. Also, because there are fewer shares that are worth more, it increases their earnings per share ratio while improving other financial metrics that make the company look more attractive.
Another reason why companies buy back their shares is because it’s a great investment opportunity, especially if their shares are undervalued. The ultimate decision on how to use a company’s profits lies in determining what can produce the best return on investment. If the company’s management and board genuinely believe in the company’s future, a share buyback is a solid affirmative of that belief, which can increase investor confidence in the company.
Not All Share Buybacks are Done for the Right Reasons
However, not all share buybacks are done for the right reasons. For instance, a company might institute a share buyback to make its earnings per share more attractive to hide other problems that could eventually hurt the stock price. Companies that use share buybacks to placate shareholders but then neglect to invest in their future growth aren’t thinking of the long-term interests of their shareholders. Some companies may use buybacks to temporarily increase their stock prices, maybe as a way to allow insiders to cash in their stock options at a better price.
That’s why investors shouldn’t select a stock based exclusively on a company’s buyback activities. While it should be a consideration when evaluating a company, it’s crucial to focus on key fundamentals that would indicate its ability to achieve steady growth with sustainable earnings. And that demonstrates the responsible use of profits to grow the business and increase shareholder value.
