…an independent advisory firm building wealth with active portfolio management

Buyback shenanigans explained

I’ve attributed some of the current market euphoria to corporations buying back their own stock, due in large part to the Fed’s suppression of interest rates.

Many of you have asked for an explanation of how corporate buybacks corrupt the market’s price discovery mechanism.  The following is a simplified explanation of how buybacks distort the appearance of earnings, thus creating the illusion of growth and lulling investors into a false state of security.

Take Bed Bath & Beyond (stock symbol BBBY), a once hot retailer.  Over the course of the past decade BBBY has reduced their outstanding stock by nearly 35% through corporate buyback programs.  If you looked solely at Price per Earnings (PE) or an earnings chart, you’d think BBBY is still growing at a substantial pace.  From $1.68/share in 2004 to $4.79 in 2014… 185% growth over a decade…WOW sign me up!

BUT now factor in inflation and corporate buybacks [each provided by the courtesy of the Fed’s loose money policies].  BBBY’s real inflation adjusted 2004 earnings in today’s dollars would be about $609 million.  Divide that by 199 million of today’s outstanding shares [NOT their 2004 outstanding shares of 300 million- remember they’ve deduced their stock pool by nearly 35% through buybacks].  That calculates to an adjusted earnings per share of about $3.06 [adjusted for inflation and buybacks].  From this vantage point, BBBY’s earnings over a decade look more like 56% [not 185%].  A sizable difference.

It’s not just BBBY.  In recent years, buybacks have reached historic levels with estimates of at least 85% participation.  Apple, ExxonMobil, IBM, MasterCard, and Pfizer…to name just a few blue chips that have engaged in large buyback programs.

Some have suggested that buybacks have inflated S&P500 index earnings per share by nearly 150%.  Thus the potential for overly zealous growth expectations and distortion of price discovery for the average investor.

Invest with caution.