Over the years it was pretty much widely assumed that stock buybacks, sometimes also called stock repurchase plans, were always a great sign for the company. The thinking was that any corporation that was willing to invest in itself was certainly worthy of an outside investment from the average investor. Stock buybacks have continued to be seen as a positive by many people, but there have been a growing number of skeptics who question the real motivation for the company buyback programs. Is the skepticism over stock buyback plans legitimate?
First of all we need to take a look at why more and more people are questioning the motives of stock buybacks. One of the main causes for concern among many analysts and economists is the number of corporations that have stock option plans that reward their executives based on an earnings per share number. Why does this matter? It matters because buying back stock serves to artificially prop up the earnings per share number by taking the number of shares outstanding down. In essence what can be done is a company can continually repurchase their own shares and the executives can take advantage of their stock options program, while the regular investor gets taken advantage of. In this situation real bottom line profits are not actually going up, but rather the continual repurchase of shares simply makes it look as if they are. The second major reason is that financial ratios are easily manipulated by a stock repurchase plan. Corporations understand that investors and analysts keep a close eye on their financial ratios, so there is the temptation to buyback stock simply to artificially prop up these numbers and make the company look like a viable investment option. Finally, stock buybacks always equal less capital for the company, which can be very negative during a tough economy as many banks have found out in the last year.
Having given all of those reasons that stock buybacks can have a negative impact on the company and stock price, I must say that this does not necessarily mean that stock repurchase plans are a big scam. It does mean, however, that you as a wise investor should look into the financial position of the company that is buying back stock. Do they have a strong free cash flow and a balance sheet that will support such a buyback plan? Sometimes if a corporation truly knows that in the end their stock is undervalued, committing capital to invest in their shares is a great idea. Broadly, stock buybacks are definitely not a scam, but in individual cases there may be some very shady reasons for them. Keep your eyes open and watch out for those companies that have no business buying back their shares, but decide to anyways.