Wednesday, January 23, 2008

What stock buybacks actually accomplish

In a nutshell, stock repurchases or "buybacks" are just a way for corporations to pay executives and other employees at the stockholder's expense.

At first glance it looks like companies are paying money to loyal shareholders when they buy back shares of stock. However, don't forget that companies also give stock options to executives and other employees, and these options end up putting new shares of stock back in to the market. When an executive exercises his stock options, he is essentially getting brand new shares of stock for an older, lower price, and then immediately selling them to the market at the higher current market price.

When you follow the shares and the money, it becomes obvious that there are two oppositely-directed cycles at work. In the first cycle, shares of stock go (1) from the market to the corporation in buy-backs, (2) from the corporation to the employee when options are exercised, and then (3) right back to the market when the employee sells for a profit.

In the other cycle, money goes from corporations to the market in buybacks, and then on to the employees who are selling their brand new shares. Since the employees in effect bought these shares from the corporation at bargain prices, there is a net flow of money from the corporation to the employee by way of the stock market. Outside shareholders may hear lots of news about all of the money being spent on share repurchases, but in the net they get Bubpkis.

Many well-respected market gurus have touted the benefits of buy-backs, including their tendency to raise share prices, but higher prices don't help new investors who are just starting to buy stocks. Besides, we are being reminded now of just how ephemeral prices can be. When the market returns to 2004 prices in a few more weeks, buy-and-hold investors will be pondering just where all of that magnificent buy-back money went.

If corporations simply gave half of their dividend profits to executives in the form of bonuses, without the pretense of "buying back shares," then at least the market would have been able to correctly price stocks without having to suffer the current crash.

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