Are share buybacks good or bad? You hear about it on Wall Street a lot, but not many people stop to analyze the implications. I’ll break it down for you.
Generally the sentiment towards share buybacks are good. Most of the time, you’ll see a stock pop upwards after announcing share buybacks.
But you might not know that there are specific times when share buybacks are good, and specific times when they actually hurt the company. Of course, no one wants to talk about the possible bad consequences, because no one likes a bear.
Well lucky for you I don’t care what other people think. I’ll tell you straight how it is, instead of trying to mask the truth.
Before I get fully into it, we need to understand what they are. And why.
Share buybacks are when a company takes some of its cash and buys some of its own stock. This will make the stock go higher short term. It lowers the number of shares outstanding, which makes each share already owned now worth more.
Why do companies do this? They’ll do it to appease shareholders. Shareholders like when their shares are worth more.
It’s also a way for the company to get rid of excess cash. Companies use cash to make acquisitions, pay dividends, do share buybacks and more. When a CEO has stock options, you can see why he’d want to pump the price up by having the company buy back shares.
Up to this point it all sounds like roses. This is where you need some real insight. On Wall Street, there’s no such thing as a free lunch, and that’s true here also.
Share buybacks are only good for the company when its shares are undervalued.
If the company is overvalued, share buybacks are not a good thing. Because when shares are overvalued, the company is overpaying for stock. This isn’t efficient use of capital. And it’s hurting shareholders.
Think about that money for a second. As a shareholder, you are entitled to a part of the company’s profits. You took risk, and you get rewarded.
Most companies pay part of their profits back to you in a dividend. Some also do share buybacks along with dividends.
But the company should never be wasting capital that’s rightly yours. When they spend that money on share buybacks to buy overvalued stock, you lose out.
You could’ve had that money paid to you in a dividend, where you could’ve employed it somewhere else. On a company that had better value, and better chance of returns.
Overpaying for overvalued stock is always a bad idea.
Doesn’t matter if it’s a multinational corporation doing it, or a small time average investor. When a company is willing to do share buybacks even when its stock is overvalued, you can see where management’s priorities lie.
In that case, they aren’t looking out for shareholders. They only care to prop up the stock, probably to personally cash in with their stock options. A management that overpays on share buybacks isn’t being efficient with capital.
Do you really want to invest with a management like that?
Too often on Wall Street people forget who the boss is. There are so many self serving CEOs and Board of Directors that are only out for themselves. But they should be serving the shareholders, not themselves!
The shareholders are not the bad guys. Don’t get misled into thinking that they are all so rich, greedy, and Scrooge-like.
So many of your everyday teachers, firefighters, and police officers are actually the shareholders. This is how their pension plans are paid for. This is how their retirements are taken care of. In the stock market.
Because Wall Street should be about a give-and-take balance. Shareholders give capital, and take some of the profits. Corporations give some profits, and take capital.
With many teams of management, it does work that way. Some of the best companies of the past decades have lasted this long due to this free market integrity.
But they got that way by treating their shareholders right.
And that’s done through responsible distribution of profits. With either dividends or buybacks or both, depending on the market conditions.
When you can understand this concept, it will help you identify the good companies from the bad. The right from the wrong. Only those who respect themselves get respect.
Understand that, and half the battle is won.
To get deeper analysis into these dynamics in business and investing, I’d recommend reading The Essays of Warren Buffett. See my other recommendations in the Top 8 Investing Books. Of course, be sure to subscribe to my email list for more posts like these.
**Share Buybacks, Good or Bad? – WW #40**
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