Monday, March 4, 2013

Share buybacks: Net is better

Share buybacks are one of two methods that companies use to return capital to shareholders. The other method is dividends.

But share buybacks have many little wrinkles. One that I will discuss here is a subtle one: Look at net share buybacks, not gross share buybacks. That is, subtract from share buybacks the cash that the company receives from the shares that it issues. It seems simple enough but companies often trumpet their share buybacks without asterisking that they offset at least a portion of the buybacks with issued shares during the year.


As an example, suppose a company has 400 million shares outstanding. If it buys back 20 million shares in one year, that's 5 percent of its shares outstanding and pretty impressive. But more often than not when you look at the company's financial statements, you will find that the drop in shares outstanding is far less than 5 percent. That's because companies continually issue shares -- and when companies are too generous with share issuance, that 5 percent drop can be anything but. For instance, if in our example the company issues 10 million shares, the drop is 2.5 percent. The gross buyback in this case is 5 percent; the net buyback, 2.5 percent. If the company issues 20 million shares, there is no drop. The gross buyback is still 5 percent; the net buyback is now 0 percent.


To be fair, newly issued shares do have benefits. They motivate management and employees; they can be used for acquisitions.

But benefits like these have to be offset against the relatively expensive cost of issuing shares. Equity is a valuable commodity. It should not be doled out like popcorn.


This problem is especially endemic with tech companies. Intel may have started this trend a few decades ago -- and it has certainly worked for them. But the trend accelerated in the early 1990s and now borders on the drunken and ridiculous. Yet companies cannot stop. Their employees or managers will just waltz over to the competition, the entity that is still generously doling out shares.


Always check how many shares companies issue when they tout how many shares they buy back.

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