Apple just announced it would use $100 Billion of its cash hoard to buy back its own stock. This Article says that S&P 500 companies spent $158 Billion during 1Q 2018 on stock buybacks – this is before the Apple announcement. The same article (from the WSJ) argues that these stock buybacks have been effective as companies seek ways to use their cash to boost their stock prices.
When a company buys back its stock, it is acting like any other investor. It uses cash that it presumably has generated from its business operations to buy stock in the stock market, thereby taking that stock out of circulation from other investors and thereby paying cash to the investor who sold it to the company. The laws of supply and demand work in this case: The company acts to reduce the supply of the stock by buying some of it back, and thereby boost the price if demand stays the same or goes up.
How should a company deploy the positive cash flow it generates from its operations, presumably from the sale of its products or services? Here are some (but not all) alternatives:
- The company could redeploy the cash back into the company in order to generate even more positive cash flow. The decision process that follows this options is whether or not the project that they are thinking of redeploying cash into is accretive to earnings. If the new project generates a greater profit than their already-existing operations, then the new project is accretive and the decision would be to go ahead with the new project. If not, then not.
- The company could pay more to its employees – either pay the existing employees more, or hire more employees, or both. Some companies are paying their employees more, either through higher wages or through one-time bonuses. However, despite low unemployment (3.9% at the latest report), there is not strong upward pressure on wages in a macro sense, meaning companies don’t yet have to increase wages significantly in order to retain or hire new employees.
- The company could keep the cash. It is nice for a company to have a rainy day fund. The problem is that they don’t earn much money on undeployed cash because they mostly invest it in safe bonds or other investments which don’t offer strong returns. It is bad for the Return on Assets ratio to keep a lot of cash.
- Dividends could be increased. This is similar to stock buybacks in that it puts money into the pockets of existing shareholders. The dividend path retains all existing stock and shareholders, whereas the buyback path seeks to pay off some existing shareholders and decrease the supply of stock.
Until wages start to grow, the buyback strategy is the best alternative for companies because it is an effective way to boost the stock price. We may be getting to the point that wages will rocket upward, but not yet. More likely, wages will move up slowly. Companies are not being evil by not paying higher wages – Apple, for instance, already pays its employees very well. Management’s first (but not only) responsibility is to its shareholders. Lastly, tax cuts and/or a change in the tax code as it relates to cash that companies (such as Apple) keep in foreign banks are not the source of the cash used to buy back stock. Rather, the companies’ operations are the source of the cash. The change in the tax code merely results in more of the cash ultimately going back into the hands of the shareholders and less cash into the hands of government.