Why do companies buy back their shares?
It’s a fair question. A reasonably profitable company will generate excess cash, often more than it can use to grow. What should it do with it?
Companies have three options: hold it, pay it via dividends, or buy back shares. In the absence of taxes, investors should be indifferent. Money earned is money earned, no matter how the company distributes it. The financial impact of each approach is the same.
While holding excess cash might encourage management to do something stupid, and tax policies formerly favored buybacks over dividends, such is not the case now. So why do companies keep buying back their shares? Often management believes their shares are undervalued. Share buybacks can indicate confidence in the future; but they can also disguise mediocre performance by artificially enhancing financial ratios.
Some have suggested that share buybacks counteract the dilution due to employee stock option plans. This is a canard. If an option program dilutes shareholders, buybacks don’t counter this. They may disguise the dilution, but they don’t reverse it.
While share buybacks don’t create economic value for investors, they do send a signal. But the intelligent investor has to discern whether the signal conveys information, or is just a smoke screen.
Douglas R. Tengdin, CFA
Chief Investment Officer
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