BULLS & BEARS: Share buybacks can be good use of excess cash

Long-term investors benefit greatly when a company is able to reinvest its excess earnings into projects that, in turn, produce a high rate of growth in future earnings.

When management can expect these investments will produce more than a dollar of value for each dollar spent, the internal compounding of reinvested earnings creates business value and will be reflected in the stock market by a rising stock price.

In addition to reinvesting earnings, a company has other alternatives available in allocating its excess cash, such as increasing or paying a dividend and acquiring other businesses.

Another use of cash that can enrich long-term owners is when a company repurchases its own shares on the stock market. By repurchasing shares and shrinking the number of shares outstanding, a shareholder’s fractional ownership in the company increases.

The reward to longterm shareholders of share repurchases is particularly significant when the purchases are made at prices well below the intrinsic value of the company. Stock repurchases in this case are also a signal to the owners that management is shareholder-oriented.

Yet while stock repurchase programs are often trumpeted in company press releases, not all share buyback programs are rational. In recent years, many companies were buying back their stock at prices in excess of the company’s intrinsic value.

In these cases it is the shareholder who chooses to sell that reaps the benefit, with the remaining shareholders footing the bill. In essence, many of those companies were paying, say, $1.25 to acquire a dollar’s worth of business value.

In addition, many of the more recent share-repurchase programs were completed to offset the shares issued from stock options granted at much lower prices.

In such cases, corporate managers were following a “buy high, sell low” strategy. Just because stock options were granted does not mean purchasing shares to offset the additional share dilution is a good idea.

Share repurchases make sense only when companies can buy stock on the market at prices below the estimated intrinsic value. And the stock market, with its intermittent bouts of manic-depressive behavior, will occasionally price a company’s shares well below intrinsic value.

Corporate managers should also carefully weigh share repurchases in contrast to expansion via acquisition, where the company must typically pay a full or premium price to acquire the entire ownership of another business.

If a company’s stock is selling at a bargain price, the acquisition of its own shares provides a more profitable use of capital. And long-term shareholders receive a larger ownership in the total enterprise.

The allocation of a company’s cash flow is a critical function for management. Investors need to monitor how effective executives are in this capacity and whether their decision-making has rewarded longterm owners.