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Stock Buybacks - Curse or Blessing?
Stock Buybacks are a Frequently Used but Controversial Instrument
You have probably often read reports like these: Company XY decides to repurchase stocks in the volume of many millions or even billions of euros or US dollars, usually to take place over an extended period. Analysts are often enthusiastic about this because stock buybacks are a potential boost for stock prices.
The mechanism behind it is simple:
Stock buybacks reduce the number of tradable stocks. At the same time, the earnings per share increase, even if the company no longer earns a single euro or dollar operationally. Therefore, such companies often resort to this measure when they are no longer growing operationally or when their management lacks ideas for establishing new business fields. Criticism grows even more when heavily indebted companies repurchase stocks instead of focusing on the financial health of their balance sheet. When profit-based compensation models for management come into play, suspicions arise that the welfare of the company is not the top priority for the company’s leaders. On the other hand, analysts point out that without stock buybacks, the index levels would be significantly lower. Stock demand through buybacks has averaged $421 billion per year in the USA since 2010 – by far the largest demand item. Without stock buybacks, greater market volatility – that is, larger price fluctuations – would be expected. According to analysts, buybacks at mature and large companies would not compromise investments but would act as a means of returning funds to shareholders, who would then use the money for other productive purposes.
Key Facts:
- Stock buybacks are controversial because they can have both positive and negative consequences.
- Through a company’s stock buyback, the number of outstanding stocks decreases. As a result, the earnings per share increase, potentially driving up the stock price.
- Critics argue that stock buybacks come at the expense of investments and operational business.
- Stock buybacks can lead to misallocations, for instance, if management compensation is dependent on the growth of earnings per share.
- Stock buyback programs are implemented much more cautiously in Europe, partly because European companies tend to hold higher cash reserves.
Our Conclusion:
As with many complex economic matters, blanket judgments are inappropriate when it comes to stock buybacks. For mature companies with large cash holdings and a healthy balance sheet, such as Apple, Microsoft, or Munich Re, stock buybacks are a suitable means of delighting shareholders in addition to dividends. However, for growth companies or companies with poor balance sheet structure and high debts, stock buybacks should be critically assessed. In these cases, the money would often be better invested in the operational business.
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