To Buy or Not to Buy, That is the Question

At a time when many stocks are languishing (the Dow is down 3.7% over the last 12 months, the Nasdaq Composite is down 6.9% over the same period and the S&P 500 has lost 8.2%), many investors are asking companies to put their cash to work and initiate stock buyback programs.
 
Is a buyback a good idea?  In 2007, many companies thought so.  According to the Wall Street Journal, companies in the S&P 500 repurchased a record $589 billion of their own stock in 2007, up 36% from the prior year.
 
Buybacks reduce a company’s number of shares outstanding, which in turn helps increase earnings per share.  Company’s stocks often advance on the news of a buy-back, but the effect is generally short-term.  According to a May 2007 article in Forbes, the increase in EPS as the result of a buyback gives only a temporary, one-time, artificial boost to earnings, while causing companies without the proper cash position to increase debt, leaving them vulnerable to a downturn in the economy.  Additionally, a study by Birinyi Associates and cited in the Forbes article showed that of 375 S&P 500 companies that bought back their shares in the six years through December 2006, the companies’ median stock return post-buyback was 56%, versus 72% at companies that did not repurchase their shares. The average return post-buyback was 102%, compared with 131% at companies that did not repurchase.
 
So what’s a company to do now that the economy has turned sour?  Buybacks fell 18% in the 2007 fourth quarter, the biggest quarter-to-quarter drop in more than five years, says the Journal, and given the current credit crunch and fall of the large financials, buybacks are unlikely to reverse this trend in the near-future.
 
If your company’s stock represents a great investment, you have idle cash in the bank and your business can self-fund its growth, a buyback can be a fantastic statement of your future confidence.  However, if you’re considering buying back stock to please a group of critical investors, think hard about whether the cash outlay will introduce unnecessary risk to the business.

— Laurie Berman, Senior Vice President, lberman@pondel.com