The Market – Stock Buybacks

February 14th, 2007

Stock buybacks were recently reported as $325b in 2006 vs $200b in 2004.  If you assume total market capitalization was $11 trillion in 2006, stock buybacks would represents around 2.955% of the total market value.  As I don’t have data on 2006 total share count, let’s simply assume $10 per share, or 1.1 trillion shares in the market.  Buying back $325 billion would represent 32.5 billion shares or naturally 2.95% of the share count. If you assume that the market does not increase its earnings but they keep constant at say $1.00 earnings per share before the buyback, effectively representing $1.1 trillion in earnings, once that share count falls after the buyback, you now have earnings of $1.03 per share, or an increase of around 3.04%.  So potentially more than 3% of the markets earnings growth in 2006 came simply from share buybacks and all those double-digit earnings growth rates the market has consecutively hit quarter after quarter may be more ephemeral than solid organic growth.

I think stock buybacks are a poor means of returning shareholder value.  The old argument that it spreads earnings amongst fewer shares and theoretically leads to a higher share price thus benefiting shareholders is misleading in the fact that a higher share price can quickly be lost in an irrational market or a market reacting to external circumstances such as economic and geopolitical risk (something that may be happening fairly soon).  And as an investor, I know I would prefer the cold hard feeling of cash to the feeling of the wealth effect.  I can spend $1 in cash dividend (naturally before taxes) for $1 in goods.  The wealth effect only theoretically gives me about $0.40 on that $1.00. 

The problem is, companies like stock buybacks as it improves their EPS growth rates and justifies their rampant stock option pools.  Furthermore, many companies fear that a dividend payment will create expectations of future consistent dividend payments that the company may be forced to reduce during adverse business conditions, thus engendering a public image black eye.  Frankly, I don’t believe in that theory.  I think it would be an excellent idea if more companies started adopting more dividend payment mechanisms, perhaps something like a special dividend that investors may not expect on the typical quarterly or semi-annual basis.  A special dividend might keep more investors in a stock for the long term knowing that management is going to efficiently return capital to the shareholders when the balance sheet of the company is healthy enough to do so.  Microsoft is a perfect example of a company with ample cash that decided to have a special dividend.  They may not want a regular dividend mechanism because they may not want to create an ‘income investor’ perception and risk losing their ‘growth stock’ profile.  Thus, the company could continue to manage its cash flow as needed for capex and acquisitions without having to worry about a ‘mandatory’ consistent dividend payment, and they return cash to shareholders to are patient enough to stick with the stock (thus providing a consisten and stable investor base).  That sounds so much better than a stock buyback program in which shareholder return is simply put off until tomorrow during which it will face price volatility and stock dilution (many stock buybacks are simply buying back dilutive stock options – hello Cisco).  More on that crazy charade at a later date. 

Entry Filed under: The Market

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