When a company earns a profit, all accounting maneuvers aside, there is more cash in the till at the end of the year than there was in the beginning.
Some of the money reinvested in the business in the form of capital expenditures (often called CAPEX), which refers to the purchase or upgrade of physical assets like property, buildings or equipment.
When management has made all of their capital expenditures, they can buy other companies, pay down debt, grow cash balances or return money to shareholders.
In the past, returning money to shareholders meant a cash dividends. Today, more and more companies buy back their own stock as a way to return capital to shareholders rather than pay a cash dividend.
Last year, the companies in the S&P 500 earned $893.0 billion. Of those as reported earnings, those companies paid out $311.8 billion in cash dividends and spent $475.6 billion repurchasing their own stock, leaving $105.7 billion for the other previously described activities.
There are several reasons for management to pursue buybacks over cash dividends.
First, management has more flexibility with buybacks. When a company cuts their cash dividend, shareholders revolt and stock prices crumble. On the other hand, companies change their buyback policies all the time without much hoopla from investors.
Second, stocks buybacks improve financial ratios. For example, the equity of a company is reduced in a buyback, but earnings are unchanged, so the return on equity (ROE) is higher after a buyback than it was before the buyback.
In theory, a buyback shouldn’t change the value of a company. Imagine a company that has 100 shares outstanding and trades at $10 per share – the market value of the company is $1,000 (10 * 100). If the company repurchases 10 shares of stock, the number of outstanding shares drops to 90 and the market value of the company is $900 – each remaining share is still worth $10, just like it was before the buyback.
However, this assumes that management is buying stock back at a good price. When buybacks are announced, management often says that they see no better investments than their own stock – a nice ‘rah-rah.’ General Electric famously bought back a tremendous number of shares prior to the financial crisis at prices well above the current level.
However, Warren Buffet said in his 2011 shareholder letter, ‘we like making money for continuing shareholders, and there is no surer way to do that than buying an asset – our own stock – that we know to be worth at least x for less than that – for 0.9x, 0.8x or even lower.’
Personally, I prefer cash in hand in the form of a dividend, especially since the tax treatment for dividends and long-term capital gains are now the same (there used to be a tax advantage for buybacks when dividends were taxed as ordinary income).
That’s especially true today when the market appears fully valued, but we really don’t have a choice in the matter and a buyback is better than simply letting cash get dusty on the balance sheet.