Stock buybacks have hit record levels – but what’s driving the growth is dangerous for you and our economy.
Total stock buybacks for 2014 amounted to $696 billion, or 4% of U.S. gross domestic product (GDP), according to Research Affiliates. That’s a lot spent on a practice that used to be tightly regulated by the U.S. Securities and Exchange Commission because it was considered manipulative.
You see, even though they’re common now, buybacks are manipulative. They make sense for some companies, but now they’re often used to inflate stock prices – and make executives rich.
In fact, most of today’s stock buybacks are not only unproductive for the long-term health of corporations, but destructive in terms of economic growth.
Here’s how bad the stock buyback “con game” has become – and how we can fix it…
How Stock Buybacks Became “Good”
Companies used to not be allowed to buy back their shares in the open market. The Securities Exchange Act of 1934 implied large-scale stock repurchases by a company could be construed as an attempt to manipulate its stock price.
That was “fixed” in 1982.
Newly appointed SEC Chairman John S.R. Shad, a former vice chairman of E.F. Hutton & Co. who sat on 17 corporate boards, pushed through Rule 10b-18. This rule gives companies a “safe harbor” for buying back shares, meaning manipulation charges would not be filed if they followed certain purchase guidelines.
Now, not all stock repurchase programs are bad. They make sense if a corporation’s earnings history is steady, if its future earnings prospects are good, and if its share price is currently undervalued.
The cost of buybacks should be weighed against a company’s free cash flow (FCF). You find that by taking operating cash flow minus capital expenditures from fixed assets and cash dividends paid.
Apple Inc. (Nasdaq: AAPL) is a good example of a company that can justify massive buyback programs.
Apple Inc has repurchased $56 billion of its own stock in the past 12 months. Even after that, Apple is still sitting on over $200 billion in cash. It has also raised its dividend out of its increasing free cash flow and spent $7 billion on capital expenditures in 2014.
Apple can easily argue its stock is undervalued since it’s trading at a trailing price/earnings multiple of about 13.2. Competitors trade at much higher multiples. Google, now known as Alphabet Inc. (Nasdaq: GOOGL), trades at a PE of 35.7. The market trades at about 18.5.
