Critics have nevertheless identified buybacks as a cause of slower economic growth, suggesting that companies are devoting scarce capital to buybacks rather than to new business opportunities. But buybacks are a symptom, not a cause, of slower economic growth. In an economic environment characterized by a lack of demand in many traditional industries, companies can destroy shareholder value by investing capital in questionable expansion efforts or, even worse, embarking upon overpriced acquisitions that feed the empire-building aspirations of overly ambitious executives.
Moreover, many companies are holding excessive amounts of cash on their balance sheets. Perhaps no company has been criticized more for stock buybacks than Apple Inc., with one commentator recently suggesting the company's stock buybacks are an indication it “is out of ideas on how to invest it.” But we are talking about a company that generates between $50 billion and $60 billion of cash from operating activities each year and that has about $155 billion of cash and liquid assets on its balance sheet even after having spent more than $100 billion on dividends and buybacks in the past two years. Meanwhile, Apple has ramped up its capital expenditures from a little more than $1 billion in 2009 to more than $11 billion in 2014, suggesting it continues to invest heavily in new ideas.
Because cash earns rates of return lower than the cost of capital for most companies, excessive cash balances destroy shareholder value. Buybacks provide a means to preserve and often enhance such value by distributing cash to shareholders, who in many cases have investment alternatives that offer greater potential returns than the marginal investment opportunities of the large, established companies that generated the cash in the first place. In part because of its prudent use of its excess cash, Apple stock appreciated more than 35% in 2014, compared to a return of about 14% for the S&P 500.
Even in cases where companies are not sitting on excessive amounts of cash, the U.S. tax code provides a means for companies to enhance shareholder value by taking advantage of the tax-advantaged nature of debt financing. Since interest payments to debt holders are tax deductible while dividend payments to shareholders are not, companies can enhance shareholder value by taking on debt to fund share buybacks so long as the bankruptcy risks associated with the extra debt do not outweigh its tax benefits. In an environment characterized by historically low interest rates on long-term corporate debt, companies further benefit by securing a long-term source of low-cost funding. Recognizing the tax benefits of debt, Apple financed about 30% of its share buybacks over the past two years through the issuance of $29 billion in debt — its first debt issuance in 19 years.
To be sure, companies take on price risk when they buy back their stock. Critics like to point out that buybacks last peaked in 2007, or shortly before the stock market crashed. But it's not clear that companies would have been better off had they instead invested their cash in risky new investment opportunities in advance of the worst recession of our time. And while there are certainly examples of companies buying back their stock on the eve of precipitous share price declines, there are also numerous examples of companies, such as Berkshire Hathaway Inc., that have effectively deployed their capital to buy back shares at favorable valuations.
