Time and time again we hear of companies looking to buy back their own stock because it “is too cheap”. There will be some situations where companies look undervalued but at current stock market valuations it is sometimes difficult to justify the “cheap” tag. If we look at the US market, we see that the Schiller price/earnings ratio for 10 year inflation adjusted average earnings now stands at 31. This compares to just 16 in “a more traditional environment” and would suggest that many company stock market valuations are taking growth for granted. They may not be as good value as it seems when companies start buying back their stock.
Why would you buy back your own stock?
A buyback programme should be earnings enhancing in a perfect world, a reduced number of shares based around the same profitability, i.e. a lower price-earnings ratio with more potential on the upside. If a buyback program is not earnings enhancing from day one then you really do need to wonder why hard earned company funds are being used to reduce the number of shares in circulation.
While we may seem a little negative on share buybacks, they do have a time and place and can sometimes give investors a useful tip of the hat that they may well be undervalued. It will then be up to investors to take a look at the figures themselves, consider the relative ratings and take it from there.
Too much cash
If we look at a company such as Apple, with literally hundreds of billions of dollars in cash, the company is set to double initial buyback resources. We know that the company is a cash cow, has been building a massive war chest for some time but surely this would be better spent investing in the company?
The problem for Apple is that it does not necessarily need any more major acquisitions on the iPhone front and the acquisition of a non-core business is risky. So, it would appear that the Apple management have decided on an ever increasing buyback program as a means of improving the company’s stock market standing and eventually increase the company’s price-earnings ratio. However, surely shareholders employ management to make these tough decisions? To build the company as opposed to buying back shares to appease the balance sheet?
Lack of ambition
The insinuation that the Apple management have a lack of ambition is something which has been doing the rounds for some time now. In the past the company has hinted at potential acquisitions with the likes of Tesla and Netflix often mentioned. However, unlike the Apple of old, the company took too long to consider these two particular acquisitions and they have moved too far ahead. Indeed, there have been rumours for at least two years that the company is working on its own electric vehicle but so far nothing has been confirmed.
While share buybacks do have a role to play when reorganising balance sheets and making shares look more attractive, they are not as positive as many people would have you believe. They may offer a short-term increase in a company’s price-earnings ratio but long-term investment is what makes or breaks a company. If you look at the likes of Apple, the iPhone and associated products cannot go on forever so what will the company have to fall back on?