Share Buybacks Hit New Record

Is this a good thing?

The volume of share buybacks hit a new record in the third quarter, totaling $234bn for companies in the S&P 500. This was a front-page story, in the WSJ at least, so I guess this is big news. But how should we think about this? Are share buybacks a good thing or a bad thing? For whom? And why or why not?

Like dividends, or debt incurrence, or wage increases or a Black Friday 30% off sale—or most anything else for that matter— the merits of share buybacks depend on the specifics of the situation and one’s particular perspective and values. Shareholders, creditors, workers and customers may all have different views, as may politicians or voters. For reasons I don’t fully understand, share buybacks have become a bit of a political football and may soon become subject to an excise tax as part of President Biden’s proposed tax plan. But why the big fuss over share buybacks? How much do the proponents and critics of share buybacks really understand about them and how they work? How much do we?

Not surprisingly perhaps, there seems to be a lot of public and some professional misunderstanding (or misdirection) regarding share buybacks, so let’s go back and review some of the basics.

What are share buybacks? A share buyback is just what the name suggests: the repurchase of previously issued shares of stock by the issuing corporation. Publicly traded companies typically do this by repurchasing shares periodically on the stock market, subject to SEC disclosure rules and trading limitations. Private companies can also buy back shares, but this does not get as much public attention. A share buyback almost always refers to the repurchase of common stock, but companies can also buy back outstanding shares of preferred stock (or bonds for that matter). A share buyback in any form is simply a return of capital to shareholders, as is a dividend (discussed below). Keep in mind that companies which issue shares of common stock are generally under no legal obligation ever to redeem or repurchase those shares, or even to pay dividends. All of these forms of shareholder distribution are made voluntarily on the part of the issuing corporation, and these decisions and declarations are made by the company’s governing board of directors as and when the directors think appropriate. Shareholders who don’t like their company’s distribution policies are free to sell their shares or vote against the directors in the next shareholder election, but they generally have no further legal recourse to the corporation or the directors. This is markedly different than in the case of corporate debt, which has a stated maturity date by which the borrowing corporation must pay back the principal amount borrowed (plus interest in the interim).

How are share buybacks different from dividends? Both buybacks and dividends are returns of capital to shareholders, but they differ in several important respects. Dividends are paid pro rata to all shareholders; if I own 1% of a company’s outstanding shares I receive 1% of whatever amount is distributed as a dividend. In a share buyback, however, the amount of money being distributed goes only to those shareholders who elect to sell their shares back to the company; selling shareholders receive an amount equal to the per share purchase price paid for their shares times the number of shares they elect to sell. If a company pays a $1bn cash dividend, that amount is paid equally (pro rata) to all the shareholders; the number of shares outstanding remains unchanged but the amount of cash in the company goes down by $1bn. In a buyback of the same size, the amount of cash also goes down by the same $1bn but the number of shares outstanding also goes down (by the number of shares that were repurchased), leaving the non-selling shareholders with a larger percentage ownership of a company with less cash and a reduced share count.

How are buybacks and dividends currently taxed? Taxation depends on the nature of the corporation and also of the shareholder, but let’s assume that we are talking about distributions made by US “C-corps” (named after a chapter in the US tax code) to individual investors holding shares in a taxable (non-retirement) account. In the case of both dividends and buybacks, the distribution is paid by the corporation out of after-tax funds; the paying corporation does not receive a tax deduction for the payment (as it does for the payment of interest on debt). The taxation of the distribution at the shareholder level depends on the form of the distribution however. In a dividend, shareholders pay federal income tax on the total amount of the dividend received, generally at a preferential tax rate (ie a rate lower than that applied to ordinary employment or interest income). In a buyback, however, shareholders pay income tax not on the total amount of money received but rather on the “capital gain” earned on the sale, that is the difference between the investor’s cost basis (purchase price) and the amount received on sale of the shares (sale price), also generally at a preferential tax rate. Both dividends and share buybacks are thus examples of “double taxation”; the amount of the distribution has been taxed twice, once at the corporate level (before distribution) and once at the shareholder level (upon distribution). This is to be contrasted with the interest paid on corporate borrowings, which is generally tax deductible by the corporate borrower but taxed as ordinary income at non-preferential tax rates to the lender (or bondholder).

Why do companies buy back their own shares? Companies buy back shares for many reasons, some more or less sound than others. Many companies buy back shares in order to offset the dilution that would otherwise result from regular share issuances, as in the case of share-based compensation expense paid to executives and employees. This is a sound and non-controversial reason to buy back shares, but it accounts for only a small portion of the amount of shares bought back every year. So what is the rest of the money being spent on?

Many companies buy back shares, sometimes in very large amounts, as an alternative to paying out (or increasing) dividends. Not all companies pay dividends, and some that don’t pay dividends use share buybacks as their sole vehicle for returning capital to shareholders. By contrast, most dividend-paying companies generally set a regular dividend amount to be paid quarterly at a set per-share amount expected to grow over time, perhaps in line with earnings growth. But quarterly earnings are volatile, and companies generally prefer that their regular dividend payments remain stable and predictable, not volatile like reported earnings. Unlike regular dividends, share buybacks can easily be turned on and off and so companies often to prefer to use buybacks rather than dividends to adjust shareholder returns when earnings (or free cash) moves up or down unexpectedly.

Another reason to buy back shares is when the company determines that it does not have better uses for the large and growing amounts of excess cash on its balance sheet. This often happens when a company matures and runs out of attractive new opportunities to reinvest capital and grow its own business. Rather than making further capital investments at low expected rates of return, or paying back debt (also at low, albeit less risky, rates of return), many companies with sustainable capital structures (not excessively leveraged) and excess cash (or borrowing capacity) will instead choose periodically to buy back their shares (or pay extraordinary dividends). The alternatives to returning the cash to shareholders are generally sub-optimal from a shareholder-value perspective: letting cash build up on the corporate balance sheet, continuing to reinvest the capital into the business at low or declining returns, or making acquisitions which often turn out badly for the acquiring company. None of these alternates are generally attractive to shareholders, who would much prefer to see excess cash returned to them directly to be reinvested in other more attractive opportunities.

These are all sound reasons for companies to buy back shares. But some companies also buy back shares for more suspect reasons. Sometimes companies buy back shares primarily for the purpose of managing reported EPS (earnings per share), which tends to go up following a buyback because of the low funding cost (interest expense or foregone interest income) and the reduced number of (repurchased) outstanding shares. (This EPS impact does not happen with dividends, a difference in accounting cosmetics which seems to fool a lot of people, including many who should know better). Why might a company want to manage EPS in this way? Perhaps because senior management gets paid in part based on the growth in reported EPS and so buying back shares seems and easy way to boost their bonuses. As you can imagine this is controversial to say the least.

Or perhaps management and the board think that increased EPS will automatically drive their company’s share price higher, which will be good both for shareholders and executives who get paid in stock or options. As noted below, however, this reflects a rather limited understanding of the complex relationship between share buybacks and stock prices. (See “Do share buybacks cause stock prices to increase”.). You wouldn’t make this mistake on your corporate finance exam, but companies and investors (not to mention politicians) often do so in the real world.

And sometimes company management and the board think they can outsmart the stock market by “timing” the purchase of the company’s own shares, buying back shares when the market price of the shares is low relative to what the company believes is the shares’ intrinsic value. This makes intuitive sense, perhaps, because who knows more about the company’s future business and financial prospects than the company’s management itself? But empirical evidence strongly suggests that companies buying back their shares generally have a poor record of market timing, often buying back shares when business is good and share prices are high and terminating the buybacks when business is bad and prices are low. This of course is just the opposite of what a good market timer seeks to do (generally also without great success however).

Who benefits when companies buy back shares? Shareholders do, but only when companies buy back shares for the right reasons, as discussed above. The benefit to shareholders comes not from increased EPS per se, but rather from the fact that shareholders can themselves reinvest the returned capital in other more attractive investment opportunities than are available to the company buying back its shares. As noted above, the alternative to a buyback (or dividend) is to let the excess capital build up on the company’s balance sheet, which all too often proves an irresistible attraction for management to spend it in less shareholder friendly ways.

Do share buybacks increase stock prices? Empirically yes, but perhaps not for the reasons one might think. I once had a colleague who put together a pitch book for corporate clients advising them to buy back shares because any increase in EPS would automatically increase their share price by the same percentage, assuming a constant P/E. Yes that is how the arithmetic works, but why should the P/E ratio stay constant when the company’s financial leverage (and risk to shareholders) increases following the buyback?

More sensibly, share prices would be expected to go up following the announcement of a share buyback (or dividend increase) when shareholders see the buyback (or dividend increase) as a signal from the company that it now anticipates a previously unexpected improvement in business conditions or future financial results. Share prices might also go up following the announcement of a buyback (or dividend increase) from a company without improving prospects when the announcement signals a future change in the company’s capital allocation policy, with a reduction in value destructive capital investment. (This sometimes happens when an acquisitive company announces that it is no longer looking to make acquisitions, often a relief to shareholders concerned with the company’s past acquisition history.)

Of course sometimes the share price goes up for purely technical reasons, perhaps due to the increased (but temporary) demand for shares from the company’s own buyback program or the covering of short positions by speculative investors wrong-footed by the company’s buyback announcement. This share impact often reverses, however, when the company is no longer in the market buying its own shares or once investors have covered their shorts.

An old boss of mine liked to explain any big change in a company’s share price by saying “more buyers than sellers” (or vice versa). And the same thing can be said about buybacks I suppose. But the more interesting question is “why”.

Why are buybacks so controversial? It beats me. The longer I live, the less I understand about what gets some people wound up. If we think of share buybacks as simply a more flexible and tax-efficient form of dividends, there would seem to be little for non-shareholders (let alone politicians) to get excited about. But that is not how the picture looks to some or our elected representatives. Here for example, is Elizabeth Warren ripping share buybacks as “nothing but market manipulation to increase executive pay”. Senator Warren is perhaps a bit extreme on this issue, but she is not entirely wrong when she says that share buybacks do nothing to enhance a company’s business operations, deliver a better product or enhance the lives of its workers or the communities in which it operates. That is correct. Share buybacks by definition distribute excess capital out of the company and return it to shareholders to be reinvested elsewhere (ie in other companies). The buyback money goes to the selling shareholders, not to customers, employees or communities. But the selling shareholders who receive the proceeds of share buybacks don’t generally burn the money, they reinvest (or spend) it elsewhere in the economy with benefits for other companies’ customers, employees and communities. And if one consider these second and third-order economic impacts as part of the overall picture, then buybacks take on a whole new complexion which Senator Warren and other buyback critics generally ignore. Let’s face it, some of these folks simply don’t like companies which earn big profits, or any profits for that matter, but they put the blame on highly visible and large buybacks which isn’t really what is getting then wound up. Senator Warren is a smart lady, but she has an agenda. And it isn’t generally business or shareholder friendly. But at least she is open and hones about it.

How will the proposed Biden excise tax change this picture? The latest Biden tax proposal calls for a 1% tax to be imposted on share buybacks. The details are a bit murky (to me) but it appears that this excise tax will be imposed on the company doing the buyback, rather than on the selling shareholders receiving the buyback funds, with no corporate income tax deduction for the excise tax paid. It is unclear if there will be exemptions for buybacks used to offset the dilution associated with employee or executive compensation or for other non-controversial reasons. But at a tax rate of only 1%, I would not expect this new excise tax to have a material impact on corporate financial policy or the volume of buyback activity. This looks to me like a (small) bone thrown by President Biden to the progressive wing of the Democratic Party, with a (small) boost to federal revenue as well.

So, are buybacks a good thing or not? Like most questions I ask, the best answer is “it depends”. Share buybacks are simply a vehicle for returning capital to shareholders (as are dividends), which can be a good or bad thing depending on the reasons it is done and who is asking the question (shareholders vs employees vs politicians). In a free market economy, share buybacks return capital to shareholders who then reinvest (or spend) it elsewhere in the economy. As such, buybacks help allocate capital to its most productive uses, which is what capital markets are supposed to do. And for that reason I vote “good”, on balance if not in all cases.

Links

Share Buybacks Hit New Record, WSJ, 12 December 2021

Biden’s Share Buyback Tax, WSJ, 28 October 2021