Recently Microsoft decided to spend $20 billion of their huge cash horde to buy back a bunch of their own stock. Why would a company do this? And what does it mean for investors?
Let’s take a simple example. XYZ Corp. has 20 million shares of stock outstanding, earned $20 million in profit last year, has $50 million in cash laying around and the stock trades for around $15 a share. So they decide to buy back 2 million shares of their own stock at an approximate cost of $30 million (2 million shares x $15 a share). That price assumes that the stock doesn’t move up or down during the buy back. When they are finished there will be 18 million shares of stock outstanding and they will have $20 million in cash left. The question is why bother?
Last year XYZ Corp. earned $1 per share in profit ($20 million divided by 20 million shares). Let’s say this year they make the same profit of $20 million. But since they bought back those shares, they will have earnings $1.11 per share ($20 million divided by 18 million shares), an 11% increase. And earnings per share are the most important thing for most investors when looking at a stock. Does this make any sense?
I think not. This is just smoke and mirrors to make the earnings look better per share. But notice in our example the company earned exactly the same profit. Think of all the different things the company could do with the money. They could give it back to the shareholders who are after all the company owners, as a dividend. Or they could buy another company in a similar business to get a real increase in profits. Or they could expand the company into new geographic areas or new products. Or invest in new systems and new equipment that will lower their ongoing costs. And instead they fall back on smoke and mirrors.
Companies will explain this by saying “Our stock is undervalued so we’re buying some of our stock as an investment”. But that doesn’t make any sense. If they pay a dividend shareholders, can decide if they think the stock is undervalued and buy some more stock with it.
Frankly I think it shows a lack of imagination on the part of management. Look at Microsoft. Their whole business is selling intellectual property. Yet with all that intellect, the only thing they could think to do with that money is a stock buy back? Pretty lame.
Now truthfully there is usually a temporary jump in the stock price when a buy back is announced. After all, the stock will be a little more scarce. But it’s not a business operation, it’s a stock market one, and that’s not what we pay management for. So be skeptical the next time your favorite company announces they are ‘enhancing shareholder value’ with a stock buy back.