Why Companies Have Been on a Stock Shopping Spree

Why Companies Have Been on a Stock Shopping Spree

Getty Images

Whatever the economy fails to deliver in the way of higher earnings per share in the fourth quarter, companies may be generating themselves simply by using some of the surplus cash on their balance sheets to buy back their own shares.

That's the message in the latest report on corporate stock buyback activity by Standard & Poor's. In the third quarter, buyback activity hit $118 billion, nearly 50 percent above year-earlier levels. But the big news, says Howard Silverblatt, senior index analyst at S&P, is that companies are buying back more shares than they need to in order to cover the dilutive impact of issuing options to employees or other similar purposes.

Indeed, Silverblatt calculates that nearly a fifth of the S&P 500 companies have trimmed their outstanding shares by at least 4 percent in the last year. Theoretically, even if those companies see absolutely no growth in their earnings from operations, their reported earnings per share could jump 4 percent in the fourth quarter.

Share buybacks have always been somewhat controversial. On one hand, if a company can't come up with a better way to deploy surplus cash, this is one way it can return it to its shareholders, albeit in a less direct way than, say, introducing or raising its dividend. Companies have announced big buybacks as a way of restoring confidence in their businesses at times of market stress, although analysts have often been skeptical that buybacks generate any kind of lasting value.

This recent surge in buyback activity, which Silverblatt dubs the beginning of a new trend, is something that investors should keep in mind next month, as companies begin to report fourth-quarter and year-end earnings. The headlines about those reports will emphasize earnings per share, not the source of those earnings, revenues or cash flow – some of the metrics that are more likely to signal a fundamental improvement in a company's prospects.

If the economy stays bumpy and operating earnings prove harder to generate – as a number of companies warned when they reported third-quarter results this fall – the temptation to boost reported per-share earnings may prove too great to resist. It will be up to investors to separate those companies that are really producing better operating earnings – something that will be worthy paying up for – from those that report higher earnings simply because those profits are distributed among fewer shares.