Lately, there are some concerns about the consistent behavior of U.S. public companies to buyback their shares. According to many, an act of corporate greed and financial irresponsibility, but, is it so?. Let us go deeper into the subject.
The share buybacks and dividends payments are the primary methods to return value to the shareholders directly. In theory, if a company has excess cash after having invested in all future products, services, and projects, they should return the excess money to the shareholders.
The most visible method to return cash to shareholders is paying a dividend. These dividends are usually a set of quarterly cash payment received by the shareholders or one-time special payments.
There is an alternative method to distribute wealth to the owners, the share buybacks. So what is it?. It using company’s cash to repurchase stock of the same company, reducing the total available shares; if a company shrink the total number of shares, the resulting earnings per share of any remaining share increases — shares bought by the company are removed.
A dividend is a one-time event, but the share buyback may have a long-lasting effect. If a company reduce its shares available, it is rewarding for long-time investors and providing them with more ownership over time. When the company buys its shares, it buys stock from short term investors and transfers the future earning to long term investors.
Accordingly to a recent press release by S&P Dow Jones Indices about the S&P 500 index in Q2 2019, dividends and buybacks have a combined yield of 5.43%, where dividends represented 2.18% and buybacks 3.25% of yield. So buybacks are the preferred method of compensation to shareholders nowadays.
S&P 500 index buybacks reached $797 billion from June 2018 to June 2019. As stated in the report, “Buyback impact remains broad, as one in four companies used buybacks to reduce share count by at least four percent and increase EPS.”
As a long term equity owner, a share buyback has many benefits. So why does it have so many detractors?. Those who are against the share buyback practice argue that companies should maximize their investments and avoid financial tricks.
But if those companies were forced to invest all excess money, assuming they have already funded what they have considered valuable, they will be forced to incur on unnecessary risk, spend on lower return projects or go out of their area of expertise.
There are cases where companies who do not have excess cash flows do buybacks and dividends consistently. These companies issue debt and use the proceeds to pay dividends and buyback their stocks. When interest rates are low, as it has been for the last ten years, corporate debt is cheap, and these companies are more willing to finance buybacks with additional debt.
This behavior is complex to understand at first sight but requires a detailed examination in most cases. It all depends on the magnitude of the additional risk the company is taking with the new debt outweighed the benefits to the shareholders
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- Michele López