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<I didn't see this get posted>
Here is a very interesting story. Any comments?
JW
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>From Nov. 15 issue of Businessweek
Stock Market Time Bomb
Buybacks and options: a lethal duo
To put it mildly, stock buybacks are on a roll. Before the mid-1980s, they
were on hardly anyone's radar screen. Yet last year, nonbank S&P 500
companies shelled out nearly $150 billion to repurchase their own shares, a
stunning $35 billion more than they paid in dividends. What's behind this
boom?
Most companies say their goal is to raise stock prices by reducing shares
outstanding, thus boosting pershare earnings. By using cash that way, they
simply cater to the shareholding public's preference for getting their
payouts in the form of capital gains rather than more highly taxed
dividends.
That, however, is not the full story. In a new study, Nellie Liang and
Steven A. Sharpe of the Federal Reserve Board note that the buyback surge
has been accompanied by a parallel rise in employee stock-option awards. And
while buybacks alone tend to push up stock prices, they find that the
combination could spell trouble for stock prices in coming years.
Stock options are a peculiar animal. Although they are a form of
compensation, they aren't recognized as expenses in income statements and
thus don't lower reported earnings. Once options are vested or exercised,
however, they would obviously reduce per share earnings if companies simply
issued more shares to meet their option obligations. And that would hurt
stock prices
Enter buybacks. By regularly purchasing significantly more of their own
shares than they currently need for option exercises, companies have not
only prevented such dilution but have also tended to push up stock prices.
And that has both enriched people holding options and pleased shareholders,
who might otherwise be upset by huge executive option awards.
The big question is how long this game can go on. Liang's and Sharpe's
analysis indicates that the rising volume of buybacks has reduced the number
of outstanding shares of large U.S. companies by about 1% a year over the
past five years--presumably producing a steady upward pressure on share
prices that has been magnified by being factored into market expectations.
The problem is that option programs have been growing by leaps and bounds.
Thus, companies have had to buy more and more shares just to offset the
number issued for option exercises. And they have had to spend a lot more
for those shares as stock prices have surged. Meanwhile, the cash received
from sales of discounted shares to employees, which helps pay for new
buybacks, has risen far more slowly.
As a result, companies have been devoting more and more of their earnings to
buybacks. Even with dividends at historically low levels, total payouts to
shareholders via dividends and buybacks have hit 80% of cash flow (chart).
And since companies also continue to spend a big chunk of their earnings on
capital investment, they have had to go deeper and deeper into debt.
Looking ahead, Liang and Sharpe think something will have to give. Over the
long run, they figure companies will continue to devote 40% to 50% of
earnings to capital investment, forcing them to cut back sharply on outlays
for buybacks. If the net shrinkage of stocks falls from its current 1%
annual pace to about a fifth of that, they estimate that stock prices could
decline by 30%.
By GENE KORETZ
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