Many companies have made it a habit to buy back their own shares when stock prices are at an all-time high. Shareholder value is destroyed by buying overpriced shares as the market believes in eternal growth. The purchased shares are recorded on the companies’ balance sheets as a negative equity item. Companies need cash to finance these purchases, and this is often made possible by interest-bearing debt. By buying back their own shares, companies bear the risk of changes in share value in addition to the risks associated with their actual business operations.
Let’s take Starbucks, a luxury coffee chain, as an example. Its annual report can be found here.
At the end of the last earnings period, the company had 1.3827 billion shares, which was 4.6% less than the previous year. Last year, the company used 86% of its equity to buy back its own shares with borrowed money. The company’s equity ratio on its balance sheet fell from 38% to 4.8%.
Starbucks remains a profitable company, even though operating profit has weakened as a result of strong expansion. If the stock markets were to collapse and demand for the company’s products were to decrease as a result of a poor economic situation, this would hit the company exceptionally hard. However, if the development continues to be favorable, buying back own shares is a way to improve earnings per share as growth slows down, and thus it supports the valuation of the stock.
How do American companies’ debt financiers view this trend of buying back own shares?