Stock Buybacks

A Prudent Asset Management Strategy Or...

by Gerald Chauma

Ticker Symbols:- Apple (AAPL) - $183.05, Meta (META) - $476.20, Alphabet Inc. Class A (GOOGL) - $168.65, Walt Disney Co (DIS) - $105.79

What Are They?

By definition, this is a process that entails a publicly listed company, buying back its shares on the secondary market from any and all investors that want to sell. Shareholders are under no obligation to sell their stock back to the company, and a stock buyback doesn’t target any specific group of holders— as it’s open to anybody. The company can use its available cash or debt (which we will touch on later in the article), to buy shares of its own stock on the open market. A company may do this to return money to shareholders that it doesn’t need to fund operations and other investments or ensure they receive a higher return on future dividends.

What Necessitates This Move...

Now in most instances, companies buying back its shares is often done to generate more value of the share price for its investors. This is coined as ‘increasing shareholder value.’ The value of the company may or may not change based on market conditions, but with a reduced circulation of its shares on the open market, this tends to prop up the value of shares being held by the shareholders. Using the simple, supply and demand rule, if there is high demand for a company’s shares, it pushes the share price up and the reverse is true.

However, some companies can implement this strategy as a way to ensure targeted dividends are met for its shareholders, for tax efficiency reasons or merely to reduce its stock dilution. Whatever the reason may be, if this strategy is not timed well and with proper planning on whether to retain the shares bought back as treasury shares or cancelled all together, can result in short term gains that may prove disadvantageous in the long term.

Leveraged Stock Buybacks

There is also a type of stock buyback called a ‘leveraged stock buyback’ where a company uses debt to buy back its shares. Now, there are obvious pros and cons to this type of stock buyback, with the obvious being the company’s books are lead-heavy with the pile of debt they just added in order to purchase back their shares. It’s mainly a defensive manoeuvre to either prevent a hostile takeover of the business by adding more debt to their balance sheets or to increase earnings per share and improve other financial metrics.

The reason why I included the last point is because most executives have an earnings per share (EPS) metric, built into their performance incentives.

This greatly increases the likelihood of company executives, pushing for stock buyback strategies even at the risk of worsening their credit ratings with the use of debt to facilitate the stock buyback. This short term outlook has an adverse impact on the business in the long term if not properly managed.

When It Works...

APPL on the 3rd of May 2024, announced that it would commit over $110 Billion for stock buybacks, financed from its cash reserves. With some analysts questioning whether the stock buyback, which is the largest in US corporate history, is being motivated by underperforming sales metrics or even if it's a prudent use of APPL’s cash. APPL isn’t the only company that engages in this strategy with companies like META ($50 Billion announced earlier this year), GOOGL ($70 Billion announced a couple of days ago) and DIS ($42.84 Billion announced in February of this year), all participating in this strategy.

And Then What...

Stock buybacks are an aftermath of the 2008 financial crisis, or at least the frequency of them. There is tremendous value in the strategy but in 2022, President Biden signed the Inflation Reduction Act of 2022 which includes an excise tax of 1% on share buybacks that exceed $1 million after Dec. 31, 2022.

Will this stop this very profitable capitalist strategy that has seen executives in these companies make millions, if not billions, not only for themselves, but for their shareholders as well, I seriously doubt that!

Posted in Stocks on May 14, 2024