The media and investors are often enthralled when a company decides to engage in a stock buyback program. Quite often the financial strength of the company is overstated and the only people who benefit from the buyback plan are a few top executives.
By looking at the free cash flow of a company before and after a stock buyback program has been completed, we should be able to determine the true financial strength of that company. In fact the Center for Financial Research and Analysis and the Corporate Library have completed a joint study to determine just that. They used the S&P 500 and examined which companies had negative free cash flow before and after.
Companies that hand out stock options or offer some other stock based bonus often use buyback programs to mask the dilution of the outstanding stock. This can certainly add value for shareholders. But, may times buyback programs can hide a slowdown in the companies business and create a boost to their earnings (EPS) growth.
A decrease in the growth of a companies revenue can actually grow the free cash flow if less capital is put to work trying to increase business growth. With this lower revenue growth the sleight of hand of a stock repurchase will show a boost to earnings (EPS) growth rate without any fundamental change to the health and strength of the company.
It turns out negative free cash flow were reported by 58 companies after a buyback program. Additionally, some businesses had negative cash flow after dividends but before they repurchased stock—a move that raised eyebrows about whether those repurchase plans are sustainable, the report noted. Beware of companies that issue new debt to finance share repurchases and use “per share” metrics to calculate executive compensation, warned Jonathan Graham, senior research associate at the Corporate Library, in a statement.
The study looked for firms that used debt to finance a repurchase and also compensated executives based partly on an EPS metrics. A total of 37 companies used the metric for at least one incentive compensation plan that was likely to be positively affected by a buyback plan. “We found that while the majority of share repurchase programs are on the up-and-up, some clearly raise questions as to who is benefiting and at whose expense,” noted Jill Lohman, managing director at CFRA in the report.
One revelation was that companies with buyback plans were more likely to pay bonuses—and at higher levels—to their chief executive officers. Over 88 percent of CEOs at such firms received an annual bonus, compared to 78 percent of their peers in the S&P 500. “At a minimum, governance is lacking,” stated Graham.
* free cash flow is the cash left over after a company pays for its operating expenses and capital expenditures.