Understanding The Pros And Cons Of Share Repurchase Plans
On Dec. 23, 2011, Apple’s stock price closed above $400 for the first time. On Feb. 13, it hit the $500 mark for the first time and it closed above $600 for the first time ahead of the mid-March release of the new iPad. The stock price peaked at $644 on April 10 before settling to around $600 since then.
With a market capitalization of $600 billion or so, Apple is the world’s most valuable company and has since announced that it will use some of its $98 billion pile of cash to buy back $10 billion of its shares over the next three years. Why would Apple do this? To make the company more valuable, of course. By decreasing the amount of shares that others own, the hope is that the value of those shares will rise.
A stock buyback program, also called a share repurchase plan, is a company’s desire to buy back its own shares from the marketplace in order to own more of its company’s stock.
Stock buybacks can happen two ways: through a tender offer or through the open market. A tender offer program will spell out exactly how many shares the company will buy back as well as what price the company will pay for those shares. If the company uses the open market, then it does what any investor would do: it buys shares at the price available on the open market. Most companies opt to buy on the open market so they are not locked in to a price that at some point they may not want to pay.
To say that a company wants to buy back their stock to increase the value of its shares is accurate, but there often are other motives which companies may never reveal. Buybacks often are depicted as a win-win for companies and investors, but in recent years some question whether companies should spend their money this way. The debate has been revived by Apple’s buyback announcement. Its founder, Steve Jobs, who died last year, made it clear that he thought it was a bad idea, but Tim Cook, Jobs’ successor, disagreed.
In order to put this in perspective, here are some pros and cons of share repurchase plans.
- When a company wants to buy back its stock, it is usually a sign that it thinks the stock is a good buy at the current price. This is seen as good news for investors who own the stock or who want to own it because the company essentially is saying that its stock is undervalued and it is betting on a brighter future.
- Stock buybacks, especially during recessions or bear markets, include an extra price support that can serve as a safety net for investors in the stock.
- If all other things stay equal, repurchasing stock means there are fewer shares to buy and that means higher earnings per share number. Some investors specifically look for large reductions in outstanding shares, and if they see that, they will buy that stock. The Washington Post Company, which hoards its own stock, is trading at about $375, so if you’ve owned it when it was trading at below $100, you are doing well.
- Companies can use stock buyback programs to cover up for financial problems. When a company buys back their own shares, it can create an artificial lift in their financial ratios, giving market observers belief that things are improving even if they are not.
- These buyback programs can allow company executives and other insiders to take advantage of stock option programs. Warren Buffett, who also opposes buyback programs, has said that employee stock option programs and buyback programs can be shady. (To learn more about employee stock programs, see Understanding Employee Stock Purchase Plans.)
- The good feelings that often surround buyback programs often cause an artificial, short-term jump in the price of the stock, allowing insiders to sell at this inflated price while individual investors are buying high.
- If a company uses a lot of cash or borrows a lot of money to buy back shares, it may not have enough money for other things such as investing in its company or buying another company.
On the surface, the pros often seem to outweigh the cons when investors look at stock repurchase plans. But here are some things that investors should look out for:
- If a company spends too much of its cash to repurchase stock, it can hurt the company’s liquidity. It’s too early to bury Sonic, but several years ago, the fast-food company borrowed $600 million to buy back its stock and its stock price has plummeted from about $23 to $8. In October 2011, it announced another buyback program, this one for only $10 million. Its stock price these days is about $7.
- If a company uses a tender offer to buy back shares and it pays too much, that can hurt a company’s value. Overpaying for anything is never a good thing, and if that happens, you don’t want to own that company’s shares.
Keep these pros and cons in mind if you are considering taking part in a share repurchase program. Doing your homework ahead of time will help you to make the best decision.
- Interviews conducted on 4/19/12