Stock Buybacks: Good or Bad?

I’ve long gone back and forth on this subject, but I think I've finally made up my mind...

First: what IS a buyback?

Share buybacks typically occur when a company has excess cash reserves (unless they're debt financing the buyback, which is a major red flag).

In essence, if a company is doing well it can afford to buy back stock – typically a good indicator for shareholders since the company has sufficient retained earnings.

When a company buys back stock, it reduces the number of outstanding shares on the market, thus increasing its earnings-per-share (EPS ratio), since there are now fewer shares available. 

This often leads to short-term increases in share price as the company (now) appears to be undervalued in terms of EPS. In turn, management receives a bonus since executive compensation is often tied to maximizing shareholder value.

Let's look at the BIGGER picture...

Unfortunately, there’s a bigger issue at play – that of long-term sustainability – and we must adopt a more holistic view. 

For instance, to compete in today’s technologically advanced business world, company’s must adopt a culture of continuous improvement for the purpose of meaningful differentiation in the fight to win, delight & retain customers.

It’s a constant battle, trying to fend off competition while maintaining profitability. 

However, to allow for continuous improvement, companies must invest heavily in R&D, capex, innovation, process improvement, upgrading its people, and other such long-term growth initiatives which will align the company for success.

Unfortunately, the overall trend appears to be going the opposite way...

Now, if a company can afford to do both (i.e. invest in innovation AND buybacks) great! But all too often, R&D is the first budget to get cut.

A great example is Amazon, with its intense customer focus and highly infrequent share repurchases (compared to industry averages).

What's the solution?

Two conclusions come to mind:

1. To remain competitive and avoid complacency, companies must invest in innovation as a means of achieving long-term sustainability (instead of short-sighted gains in EPS), and;
2. To maintain long-term viability, companies must adopt and promote a culture of continuous improvement & innovation by shifting its executive compensation model away from the maximization of (short-term) shareholder value, and instead, adopt a system which rewards innovative thinking, idea testing, and which does not punish failure in the pursuit of groundbreaking innovation.

Within corporate America, this culture of focusing (first) on shareholder value is no longer an effective long-term strategy, given the accelerating growth curve of new technologies, and the continuous shortening of the technology life-cycle.

As evidence, look no further than best-in-class companies such as Zappos, Apple, Google, and Amazon, whom each make considerable routine investments into customer service and R&D.

Those organizations which place its people and customers FIRST will inevitably reap the benefits of long-term growth and subsequent shareholder value, rather than superficial short-term bumps in EPS.

1) Happy Employees

=

2) Happy & Loyal Customers

=

3) Long-Term Sustainable Revenue for Stakeholders

Therefore, before deciding whether a particular buyback is good or bad, I suggest we take a moment to analyze cash flows and determine:

1. How the buyback is being financed (cash or debt?); and,
2. Whether the company's ratio of investing cash flow-to-revenue has been steadily improving; to suggest continuous reinvestment of capital.

If a company can successfully buy back stock while avoiding additional debt and continuing to invest in its future, such an organization is primed for long-term growth, satisfied customers, and continuous increases in shareholder value.

"Shareholder value creation is the outcome–not the driver–of effective business strategy, which should be aimed at profitably creating and retaining satisfied customers."

–Leonard Sherman, Columbia Business School