Here’s a simple math problem. Let’s assume that that the top number of a fraction (the numerator, which in this case we’ll say represents a company’s profits) is 3. And we’ll pretend the bottom number (the denominator, which in this example represents the number of shares outstanding), is 4. By dividing the earnings by the number of shares, we get 0.75. We’ll call it $0.75 per share.
Now let’s say that management wants to get that number higher to satisfy shareholders. But the company has this problem: Profits aren’t growing much, if at all. What to do?
One solution is to shrink the bottom number. So the board of directors authorizes a share buyback program, thereby shrinking the denominator from four to three. Voila! The company’s earnings just increased by 33 percent to $1 per share — without a single penny of additional earnings.
Welcome to the world of financial engineering. Or, in the best of cases, enhanced shareholder value. For investors, it pays to know the difference.
In a world of super-low borrowing costs and subdued consumer demand, share buybacks have become all the rage. For the 12 months through September 2014, companies in the S&P 500 index spent more than $500 billion on share repurchases, a 27 percent increase from the year before.
Which raises the question: Do share buyback programs really increase shareholder value, at least as measured by near-term market outperformance?
Though there are exceptions, evidence suggests that the answer is yes. A study by S&P Capital IQ found that, on average, share buyback announcements between January 2004 and July 2013 preceded excess returns for U.S. companies by 1.38 percent over the following year. An exhaustive study of 17,487 buybacks in 32 countries between 1998 and 2008, published in the Harvard Law School Forum on Corporate Governance and Financial Regulation, found similar short-term outperformance and average long-term outperformance of about 25 percent.
But there could be a darker side to the strategy as well. Writing in the Harvard Business Review, University of Massachusetts Lowell economics professor William Lazonick argues that buybacks divert money from capital investment that could help businesses grow over longer periods.
He also blames share repurchases for opening a gap between productivity gains and wage growth. Since executive compensation often is tied to profits, top management can be incentivized to increase earnings by any means possible.