Are Stock Buybacks Dangerous?

Much of the windfall that U.S. corporations experienced with the Trump tax cut went into buying back their stock. The stock buybacks accomplished their intended purpose which was to support or drive up stock prices. This has helped keep the stock market rally going. But, is there a dark side to all this? Are stock buybacks dangerous at some level?

Stock Buybacks

Investopedia poses the question, why would a company buy back its own shares?

The most visible result of share buybacks is that it preserves or increases share price. But, there are three other good reasons to buy back shares.

Consolidation of Ownership
Reduction of Dividend Costs
“Remedy” for Undervalued Shares

Companies issue shares to raise equity capital to fund expansion, but if there are no potential growth opportunities in sight, holding on to all that unused equity funding means sharing ownership for no good reason.

Businesses that have expanded to dominate their industries, for example, may find that there is little more growth to be had. With so little headroom left to grow into, carrying large amounts of equity capital on the balance sheet becomes more of a burden than a blessing.

Shareholders demand returns on their investments in the form of dividends which is a cost of equity – so the business is essentially paying for the privilege of accessing funds it isn’t using. Buying back some or all of the outstanding shares can be a simple way to pay off investors and reduce the overall cost of capital. For this reason, Walt Disney (DIS) reduced its number of outstanding shares in the market by buying back 73.8 million shares, collectively valued at $7.5 billion, back in 2016.

Another major motive for businesses to do buybacks: They genuinely feel their shares are undervalued. Undervaluation occurs for a number of reasons, often due to investors’ inability to see past a business’ short-term performance, sensationalist news items or a general bearish sentiment.

Therefore, a company that is not growing as fast as it used does not need to share ownership in order to raise capital to expand. It can reduce dividend costs by having fewer shareholders. And, the boost in stock price caused by share buybacks can fuel a bullish sentiment for their stock and further boost the share price.

Stock Buybacks Did Not Lead to Job Expansion in the USA

Part of what sold congress on the Trump tax cuts was the idea that US companies would bring offshore capital back to the USA and invest it. There was supposed to be lots of job growth as companies “invested in America.” The fact that much of the repatriated money went to buy back shares has not been appreciated by those in congress who thought they were essentially voting for job creation back home and not support of corporate share prices.

Are Stock Buybacks Dangerous?

The responsibility of a corporation is to its shareholders. As such, stock buybacks may well take precedence over R&D, expansion, or raising salaries. But, is there a risk to you, the shareholder? If you are seeing the share price of your favorite stock go up and up, what is there to complain about? The risk is that a company may be building a “house of cards” by artificially raising share price when business is not all that good. The answer to whether your company is doing this comes from an assessment of intrinsic stock value. The long term value of your investment will depend on its ability to make money with its business plan well into the future. If this part is solid, you can rejoice in your share price going up. If you do not see a happy future for the company, then stock buybacks are dangerous and simply being used to hide long term problems. At that point, you should start to sell and find other long term investments.

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