5 Ways That Stock Buybacks Can be Bad

Stock buybacks are the preferred method of many companies to return money to shareholders. This involves the companies buying back their own shares on the open market, then effectively destroying the shares.

When done right, this is good for investors as it reduces the number of outstanding shares and raises the value of each remaining share. This leads to a higher stock price.

But many companies are doing it wrong. In some cases, stock buybacks do more harm than good for investors, employees and the world.

Here are 5 ways that stock buybacks can be bad.

1. Borrowing money to fund share buybacks

Some companies that carry a lot of debt are also spending billions on share buybacks. In some cases, they are even taking on new debt to buy back more shares.

This can provide a short-term boost for stock prices, but it can also be a disaster for the long-term growth of companies. Eventually, the debt is going to have to be paid — with interest.

The amount of corporate debt has really skyrocketed since the 2008 financial crisis, now reaching a record of $9 trillion in the US alone. This is now seen as a major systemic risk to the global economy as companies have never owed this much money before.

A lot of this debt was actually not used to fund growth, but instead used for share buybacks. Now that interest rates are rising, a lot of the debt will need to be refinanced at higher interest rates.

These interest payments will be a drag on earnings for the coming years and decades. But if things get really bad, these high debt loads could become downright disastrous and lead to mass defaults and a new financial crisis.

2. Not paying their workers a living wage

A lot of recent criticism against stock buybacks is that they are often done by companies that aren't treating their employees well.

According to a 2015 study by UC Berkeley, government welfare programs for low-wage workers cost American tax payers over $150 billion per year.

For example, many retail and fast food companies pay a very low starting wage and many of its employees only get part-time work with few benefits. Because of this, there have been many reports of their employees requiring government welfare programs like food stamps.

At the same time, many of these companies have bought back tens of billions worth of their own shares in the past decade.

Companies that claim they can't afford to pay their workers a living wage don't have any business spending billions per year on stock buybacks.

3. Management often has bad incentives that lead to a short-term focus

Company executives often have bad incentives that make them benefit personally from share buybacks.

This is a massive conflict of interest that causes many companies to focus on boosting earnings and stock prices in the short-term, instead of investing for long-term growth.

Here are some common performance incentives that make companies biased towards share buybacks:

  • Stock options: Company executives often get part of their salary from stock options, which aren't worth much unless if the stock price exceeds a certain threshold. This gives an incentive to focus on increasing the stock price.
  • Earnings per share: When compensation is tied to earnings per share, this causes a huge incentive to buy back shares. Share buybacks lead to an instant boost in this number because they reduce outstanding shares, so the earnings are now higher for each remaining share.
  • Stock price: When salaries and bonuses are tied to the stock price, this also causes a bias because the earnings per share increase leads to increases in stock prices.

All of this leads to a conflict of interest for company management where they are incentivized to buy back shares, even if it means losing opportunities to invest in long-term growth.

4. Not investing in research, development and future growth

Cash is the lifeblood of any business. How companies use their cash is often the strongest determining factor of their future performance.

When companies buy back shares, they are using the cash for something that doesn't improve their core business in any way.

In some cases, companies may be spending less on new factories and equipment, skimping on research and development or not investing in their employees.

All of this can lead to reduced future growth. Not only for the individual company, but also the economy as a whole.

Because the economy is regarded as being "late-cycle" — as in, we are probably getting closer to a recession — many companies actually stop investing aggressively in the future and instead use excess cash for share buybacks.

5. Buying back shares that are overvalued

One interesting feature of stock buybacks is that they tend to peak late in the economic cycle, often when stocks are at all-time highs.

This means that companies are buying back the most shares when they are most overvalued. Conversely, stock buybacks are much less common during bear markets or recessions, which is the exact time when stocks are cheap.

When a company's stock is expensive, it would be much smarter to simply hoard the cash and wait until the stock becomes cheaper.

There are many cases of companies buying back shares at all-time highs, only to see the shares trading for much cheaper a few months or years later. This really shows that companies themselves are just as bad as most investors at timing the market.

When companies pay way too much for their own shares, it is just like throwing the money out the door. This destroys value and is clearly against the long-term interest of investors.

Written by
Founder and CEO of Stock Analysis
Edited by
Head of Content at Stock Analysis