Misconceptions of the Times

With the prices of many big-name technology stocks at historic highs, it’s become easy for the financial media to score quick points by writing pieces about speculative bubbles and self-deluded investors, pieces like the slam of IBM in Sunday’s New York Times. The story, headlined “Just Another Round of Technology Delusion,” argued that the huge jump in Big Blue’s shares last week following the company’s much-better-than-expected earnings report was the product of unjustified “investor optimism,” which we all know “can cover a multitude of sins.”

Now, unjustified optimism is indeed a worthy target (one I’ve shot at more than a few times). But IBM is not, at least not after a quarter in which its PC sales jumped 50 percent from a year ago and overall sales were up 15 percent, even as earnings leapt 42 percent. IBM sells too many products, has to invest too much capital, and is too hardware-driven ever to be as profitable, or as valuable, as a Microsoft or a Cisco. But its recent performance has been spectacular, especially at a time when the marketplace has been full of rumors about declining technology spending and shrinking PC sales.

Not surprisingly, then, the Times’ story was full of questionable comparisons and of supposed problems that bullish investors are senselessly ignoring. The most curious of these supposed problems is the shrinking of IBM’s shareholders’ equity, which has fallen by 22 percent in four years, “eroded mainly by IBM’s share buyback program.” All else being equal, a sharp reduction in the number of a company’s outstanding shares would usually be considered a good thing. If you think of a share of stock as a claim on a company’s profits, then the fewer the number of shares, the more profits there are for each shareholder.

Still, IBM has been borrowing money–$2.1 billion in the last quarter alone–to buy back those shares, and this the Times frowns upon. The implication of the story, in fact, is that Big Blue is mortgaging the future to make its present look better. The problem is that the critique of the buyback program rests on a fundamental misconception, which is that debt is necessarily more expensive than equity. It’s not.

A company can raise money in one of two ways. It can borrow money, normally by issuing bonds. In this case, it’s easy to see that the company is paying for the money it’s borrowed, since the bondholders get 7 percent interest every year.

On the other hand, a company can sell equity (shares of stock). In this case, it’s harder to see how the company is paying for the money, since it doesn’t literally pay stockholders interest every year. But it is paying for the money nonetheless, either in the form of dividends (quarterly payments of cash to every shareholder) or in the form of dilution (more shares means less for each shareholder).

Think of it this way. If you ran a business, and wanted to expand it, and in order to raise the money to do so you sold 10 percent of the company to an outside investor, would you feel that the money that investor gave you was free? Of course not. The money cost you 10 percent of your future profits. Whether that 10 percent of your future profits (let’s call it the cost of equity) was more or less expensive than the interest rate you would have had to pay a bank to borrow the money (that’s the cost of debt) would obviously depend on your business. But you wouldn’t automatically assume that selling 10 percent of your company was cheaper than going into debt.

In other words, equity capital has a cost, just as debt capital does. And sometimes–more often than not, actually–the effective cost of equity is higher than the cost of debt. When it is, buying back shares can be a sensible decision, since what you’re doing is taking out an inexpensive loan (issuing bonds) to pay off a more expensive loan (buy back shares). That’s especially true when you consider that interest payments–which go to bondholders–are tax-deductible, while dividend payments–which go to stockholders–are not.

This may seem a bit abstruse, but it’s important. The idea that equity capital has a cost, just as debt capital has a cost, is central to modern finance. IBM understands this. The Times , apparently, doesn’t.