Credit: Shutterstock photoWe are right in the thick of another earnings season and will soon have a good idea of the state of Corporate America. Unfortunately, this season has been filled with duds, with Microsoft, Google and Apple all falling short over the past week. This week, the spotlight remains on technology when Facebook and LinkedIn report first quarter results. Earnings season has traditionally revolved around both earnings per share and revenue, but this doesn’t tell the whole story.
During quarterly results, many companies also reveal key financial metrics and whether they are returning cash to shareholders. This typically comes in the form of a buyback program or dividend payment. For example, Starbucks announced they would repurchase $100 million in shares during its meager earnings call. The move not only rewards shareholders, but provides a much needed boost to Starbucks' bottom line.
Buybacks are frequently a good way for companies to spend their additional cash and also return value to shareholders. In the past, companies like Microsoft and Apple have been some of the largest companies to participate in capital return programs. Regular buyback programs are widely considered to benefit both shareholders and the company’s stock, but that’s not necessarily the case today.
Buyback Programs
By definition, a stock buyback is when a company purchases its own shares in the marketplace. Typically, buybacks are carried out in two ways: the company repurchases shares from existing shareholders or simply purchase outstanding shares on the open market. This has been found to benefit both shareholders and also improve critical financial metrics like earnings per share. A company’s financial statements are a strong indicator whether the stock will swing up or down.
Many investors favor corporate buyback programs because they have the choice whether or not they want to participate. By not participating, investors defer taxes and are given the opportunity to earn additional capital gains. On the other hand, corporations tend to undertake buybacks when the market is on the verge of topping out. Many companies will pursue these programs during bull markets and halt buybacks when the stock starts to decline. This creates a false signal that improved earnings are driven by organic sales growth, thereby destroying investor’s value.
Shareholders
Shareholders frequently prefer buyback programs despite some of the risks we have already discussed. Put simply, when shares are repurchased, the percent of ownership held by each investor increases due to a decline in the total number of outstanding shares on the market. The company is concentrating its shareholder value and spreading the same market cap across fewer shares, thus generating higher returns. Unfortunately, this idealized situation does not always hold. More often than not, companies will pursue a buyback program to artificially boost earnings and give the stock a quick pop. This undermines long term shareholders who aren’t looking to make a hasty dollar but rather develop a diversified portfolio.
Stock Prices
If you couldn’t guess already, companies will repurchase shares to artificially inflate short term earnings. Apart from boosting EPS, a strategic buyback can reduce the number of assets on the balance sheet. Subsequently, both return on assets and return on equity will actually increase because assets have declined and there is less outstanding equity. For the most part, strong finances are enough to give shares a quick boost. Just last week, shares of both IBM and VMware surged on talks of a stock buyback. As a result, companies are pushed to undertake buybacks just to satisfy short-sighted investors.
Final Take
Successful companies inevitably get around to returning cash to its investors, whether that’s through repurchasing shares or regular dividend payments. Buybacks have been the weapon of choice lately, feeding investors with strong earnings and climbing stock prices. However, stock buybacks are not always the golden ticket to returns and should be viewed with caution.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
