Why Do Corporations Buy Back Their Own Stock?

By the end of 2013, corporations had spent $477 billion to buy back shares of their own stock. In 2014, Goldman Sachs predicts that corporate buybacks will increase 35 percent. Buybacks can be either good or bad, depending on the reason that companies purchase their own stock. Many economists worry that today’s rampant buybacks spell bad news for the American economy.

The Motives Behind Stock Repurchases

Sometimes, at the end of a quarter, companies find themselves with extra cash. Sometimes, they use that cash to buy back some of their shares. Executives usually argue that the company is doing so well that it should invest in itself. They also argue that buybacks put cash in shareholders’ pockets.

In truth, anyone who has an MBA or wants to apply to an MBA program will admit that stock buybacks aren’t always valuable to shareholders. Buybacks can be either good or bad depending on why they’re done:

• Good reason: Current share prices are below the stock’s legitimate economic value. Many companies say that buying back their own stock at favorable share prices is the best use of their cash. The best companies justify the price and returns on their repurchases just as clearly as they would justify investments and acquisitions.
• Bad reason: Repurchasing stock improves financial ratios, but improved ratios don’t reflect real business value. Buying back stock decreases both the number of outstanding shares and its assets, namely cash. Fewer available shares can make price-to-earnings (P/E) ratios and earnings per share (EPS) look better, and less outstanding equity increases a company’s return on equity (ROE). In the same way, less cash makes return on assets (ROA) look better.
• Good reason: Reducing outstanding shares prevents a hostile takeover. When executives or boards want to prevent a hostile takeover, they may purchase the company’s outstanding shares to keep a hostile party from gaining majority ownership.
• Bad reason: Executives exercise a lot of stock options, and the company has to mop up afterward. Executives who cash in a lot of stock options create additional equity in the market, reducing the total fractional ownership of all employees in the stock. Buying back stock decreases the dilution, but the company has to repurchase the stock at its present value after an executive has sold it and made a huge profit.

How do Buybacks Affect Shareholders?

Stock buybacks can temporarily boost lagging share prices, but the company must have a sound reason for expecting its stock to rebound. If it doesn’t, the repurchase may generate a short-term boost to coincide with the end of a reporting period, but it won’t translate into lasting share value.

Many stock buybacks are happening because companies have extra cash, but they’re unwilling to spend cash on business expansion, hiring or salary and wage increases. It’s the worst of Catch-22s: Businesses have insufficient confidence in the economic recovery, which causes them not to invest, but the economy needs businesses to invest if it’s ever going to recover.

Shareholders receive cash in their pockets after the company purchases shares from them, but they lose their ownership stakes in the company. Dividends, on the other hand, put money in shareholders’ pockets without requiring them to give something up. If shareholders want to unload sluggish company stocks, then they might benefit from a buyback. Unfortunately, if the current shareholders don’t believe in the long-term value of the stock, new shareholders probably won’t, either.

How Do Buybacks Affect the Economy?

Robert Reich, President Bill Clinton’s Secretary of Labor from 1993 to 1997 and current Chancellor’s Professor of Public Policy at the University of California, Berkeley’s Goldman School of Public Policy, has expressed concern that corporate performance is measured by stock performance instead of on sales revenue. He points out that buybacks raise share prices and increase executive bonuses that are tied to share prices, but they don’t stimulate the overall economy because companies aren’t putting money in workers’ pockets.

McDonalds, for example, paid $6 billion to repurchase stock in 2013. It could have paid an additional $14,286 annually to each of its restaurant workers. More money would unquestionably give workers more spending power, some of which would come back to McDonalds. Ultimately, by spending on buybacks, corporations are delaying economic growth for all. In the quest for short-term profits, they’re mortgaging their own futures.