Goldman Sachs to Companies: Stop Buying Back Your Stock

Buy other companies instead.

Inside the Stock Buyback Bonanza

It looks like Goldman Sachs doesn't agree with Carl Icahn on at least one big issue: share buybacks.

While the billionaire activist investor has continued to push Apple to purchase more of its stock, Goldman has published a note recommending companies stop spending their cash on buying back their overpriced shares and instead use those overpriced shares to buy other companies' equity. As the bank puts it, "U.S. equity valuations look expensive on most metrics," with the typical stock in the S&P 500 now trading at a price equal to more than 18 times forward earnings.

In the note, "What managements should do with their cash (M&A) and what they will do (buybacks)," Goldman strategists led by David Kostin argue that the current price to earnings (P/E) expansion phase has lasted 43 months and will likely end when the Federal Reserve starts raising interest rates, which the bank now expects will happen in September. As a firm, you would much rather buy back your stock when it's trading at lower P/E multiples and get a better price. But as it turns out, corporate managers (much like investors) are pretty bad at timing the stock market. Using history as a guide, the last time buybacks were this high was in 2007, right before equities crashed during the financial crisis, Goldman notes.

Exhibiting poor market timing, buybacks peaked in 2007 (34% of cash spent) and troughed in 2009 (13%). Firms should focus on M&A rather than pursue buybacks at a time when P/E multiples are so high.

However, Goldman doesn't expect companies to listen to its advice. The temptation to give investors what they seem to want is just too much.

We forecast buybacks will surge by 18% in 2015 exceeding $600 billion and accounting for nearly 30% of total cash spending. We recognize activist investors often advocate for firms to return excess cash to shareholders via buybacks.Tactically, repurchases may lift share prices in the near term, but in our view it is a questionable use of cash at the current time when the P/E multiple of the market is so high. In our view, acquisitions – particularly in the form of stock deals – represent a more compelling strategic use of cash than buybacks given the current stretched valuation of US equities.

Companies in the S&P 500 have so far spent a whopping $2 trillion repurchasing their shares over the past five years. 

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