Share buybacks or share repurchases can distort a firm’s results and delude the public. These events hike earnings per share (EPS) without growth in the firm’s basic value. The baseless boost in EPS could lift a chief executive officer’s (CEO) bonus. So, is a share repurchase plan the best use of a company’s funds? Who enjoys buybacks except the CEO? Let’s examine buybacks and then look at Apple’s repurchase activities over the past eight years.
Share buybacks, sometimes called stock buybacks or share repurchase plans, happen when a firm buys its shares on the stock market or elsewhere and retires them. This act reduces shares outstanding and hikes earnings per share. Here is a share repurchase example:
Impact of Company ‘X’ Repurchasing 100,000 of its 1 million Outstanding Shares
|Before Buyback||After Buyback||Comments|
|Shares outstanding||1 million||900,000||Purchased 100,000 shares at market price and voided them|
|Earnings||$1 million||$1 million||No change in underlying business|
|Share price||$10/share||$11/share||Assume share price rises because of demand for 100,000 shares (10%) repurchased|
|Earnings per share (EPS)||($1 million/1 million) $1/share|
|Assume no earnings increase|
|Price to earnings ratio (PE)||(10/1) |
|If the share price remained $10/share, the PE ratio would be 11|
How Does a Firm Buyback its Shares
Firms buyback their shares in three ways:
- On the open market, like everybody does, is the most common
- A tender offer is less popular. It states the number of shares the firm wants to buy, the price range, and expiry offer date
- A private buyback is the least common. The firm negotiates privately and directly with a large individual shareholder.
Why Buyback Shares
Firms buyback shares with excess cash on hand and sometimes with loans. But why do they buyback their shares? Why not invest funds to grow or modernize their businesses? These are their reasons:
- With excess cash: Where the company has excess cash and no investments available to generate returns higher than the share buyback.
- Undervalued shares: In theory the additional demand for shares will cause the undervalued share price to rise. Existing shareholders might enjoy a sustained price rise if they hold their shares. If they sell now at the higher price they could get an immediate benefit. But shareholders who sell might incur capital gains taxes.
- Increase returns to shareholders: Because buybacks under normal situations will increase the share price, firms believe this is a good return for shareholders. But this reasoning doesn’t benefit shareholders who keep their shares. As with the previous reason, real benefits come from a sustained price increase.
- Increase earnings per share (EPS): As the above table shows, a buyback increases earnings per share with no lift in the firm’s basic value. Because the number of shares reduces, like EPS, returns on equity (ROE) will rise, too.
Apple’s Share Repurchase Plan 2012-2020
Apple initiated a share repurchase plan in 2012 to buy $45 billion of its shares on the open market over three years. Since then Apple implemented several repurchase plans and by its first quarter 2020 (its year-end is September), Apple spent a whopping $326 billion buying back its shares! During the same period it paid $92 billion in dividends to shareholders. Apple bought its shares on the open market and by private negotiations.
To understand the context of Apple’s spending on its repurchase plan, let’s review its 10-K reports. We will look at capital expenses, research and development, cash on hand, and how it funded the over $400 billion returned to shareholders.
In 2012 Tim Cook reintroduced dividend payments at Apple, and started a massive share repurchase plan. The late Steve Jobs did not believe in paying dividends and buying back shares. Apple accumulated substantial cash during his watch and held it in the business. The chart above shows, on average, Apple held a net of about $100 billion in cash and marketable securities at each quarter’s end between 2012 and 2019.
Apple, flush with cash, is doing shareholders a good turn by buying back its shares. It has substantial surplus cash and is spending huge sums on research and development and on capital expenditures. So it’s wise to distribute funds. Buying back shares does not commit the firm to shareholders, unlike paying dividends. Once a firm starts paying dividends, it does not want to cut its dividend as that’s a bad message to the market and its shareholders. Then again, dividends are double taxed. The firm pays them out of after-tax income and shareholders pay taxes when they get them.
Microsoft, Wells Fargo, MacDonalds and others have been spending billons buying back their shares. In 2018, US companies spent over one trillion dollars buying back their shares. This begs the question: how much of the present stock market’s record run is real? What if firms stop buying back their shares? Are earnings supporting share valuations? We will get that answer at the next downturn!
Buybacks reward short term shareholders. We should require firms to do these actions before we approve a buyback:
- Separate financial results and ratios to show pre buyback effects
- Isolate buyback effects and exclude them from CEO and executives’ bonuses
- Firms should not borrow to repurchase their shares. If they can’t fund their buyback program from internal cash generation, they should not buyback their shares
- A majority of non institutional shareholders should approve a buyback
- Firms should buyback their shares on the open market only, never by private placements
The average investor gets excited when EPS rises. He or she believes underlying earnings (profitability) are rising. But share buybacks could cause the increase! That’s what happened in the second quarter of 2019. Excluding changes in the number of shares, EPS for S&P 500 companies shrank. Reductions in share count alone produced the 2.1% EPS growth. The day of reckoning for firms borrowing to buyback their shares is around the corner.
© 2020 Michel A. Bell
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