What a lot of companies did with their cash in the go-go Nineties was buy back equity, then funnel the shares into generous employee stock option plans (ESOPs). The theory behind all the repurchasing: aligning workers’ interests with that of shareholders would spur productivity and performance.
A worthwhile goal. But in reality, ESOP-driven buybacks programs have a nasty habit of backfiring. As Willens points out, companies in the Nineties usually repurchased their shares at market prices. Employees, however, typically bought shares for substantially less under their ESOPs. Thus, employers not only took a loss on the deal, they essentially blunted the whole purpose of the repurchase program — to boost share prices.
In some case, employees exercised so many options that the total number of shares outstanding remained unchanged. In a few instances, ESOP-related buyback programs actually increased the number of shares on the open market, ultimately lowering a company’s earnings per share.
Buyback proponents say the greater the percentage of shares a company retires the better that company’s stock generally does. For a buyback program to be most effective, they claim a company needs to reduce the number of shares outstanding by at least 3 percent over the previous year.
But large repurchase programs require a whole lot of capital. Critics of buybacks contend that companies can put their cash to better use. They also point out that investors are more likely to reward a company that attempts to grow it business — rather than artificially inflate its stock price.
That’s particularly true for companies in high-growth sectors. Dan Buddington, an analyst at Stern Stewart, says portfolio managers are more likely to embrace — or at least overlook — buyback programs launched by old-line businesses. “There are simply less investment opportunities to be had in mature industries,” he explains, “Investors are more accepting of that.”
But even blue chip corporates can set off alarms with a hastily conceived repurchase program. Such plans often tip investors that corporate managers have an unhealthy obsession with stock market and economic conditions, rather than building long-term value. Notes Willens: “Buy-backs are frequently one-off, ad hoc reactions.”
This is not to say buyback programs are always a bad idea.
When the ROI in a share repurchase program exceeds that of returns on capital projects, for example, funneling cash back to shareholders can be a smart play.
Buy-backs are not a one-size fits all proposition, however. Many analysts and academics say the success of a buyback programs depends largely on the consistency and reliability of a company’s earnings.
Certainly, executives considering a buyback better have a pretty good idea what their company’s earnings will be over an extended period of time. The more predictable those earnings are, the less risky it becomes to shuttle cash back to shareholders.
James Gentry, a finance professor at the University of Illinois (Champaign-Urbana), maintains that a company’s discretionary cash flow — not operating cash, mind you — should be high enough to sustain a repurchase. Gentry defines discretionary cash flow as operating cash flow minus working capital, interest payments and dividends.