Question

Corporations investing in both debt and equity securities. But, one interesting activity in the current investment world is corporate “stock buybacks.” Do a little research and see if you can find out why corporations are doing this at such a frenzied pace and what the effect is on both the corporation and the stockholders who are selling their stock back. Do you have any feelings either way on this practice? (Short paragraph please)

Answer 1

Share buybacks stem from the assumption that the job of management is to maximize shareholder value. Therefore, the thinking goes, whenever management cannot find investment opportunities whose return exceeds the cost of capital, that management should instead return the capital to its shareholders.

In some cases, management may feel that the company’s share price is undervalued and fairly decide that the best return on investment would come from buying its own shares. This idea has lately been extended even further, with some companies now borrowing money to repurchase shares.

However, with public shares at record levels, swapping in debt for equity is less clear-cut. Such a swap might have darker motivations, such as leveraging-up the balance sheet when the company is anticipating a potential takeover bid. Here the buyback becomes part of a management entrenchment move, which is far different from a return of investor capital.

The most commonly heard criticism of share buybacks is that, in practice, they are used mainly for improving reported earnings per share (EPS) by reducing the number of shares outstanding. This, critics argue, is simply a way to manipulate EPS and, in the process, benefit executive compensation formulas. Not only is that hardly a return of capital, it’s particularly upsetting to those that subscribe to the stakeholder model of corporate behavior — that is, the corporation must exist for greater purpose than just maximizing profit to benefit executives and shareholders.