In defense of share buybacks

In defense of share buybacks
© Greg Nash

Senate Democrats are considering an array of new taxes to pay for their large budget bill. One tax being considered imposes a 2 percent tax on corporate share repurchases. It has been a rough couple of years for share repurchases. They continue to take a beating from buyback bullies on both the right and the left. How frequently do Sen. Bernie SandersBernie SandersSanders on Medicare expansion in spending package: 'Its not coming out' Briahna Joy Gray: Biden must keep progressive promises or risk losing midterms Overnight Health Care — Presented by Carequest — Study finds Pfizer vaccine almost 91 percent effective for 5 to 11 year olds MORE (I-Vt.) and former President TrumpDonald TrumpGrant Woods, longtime friend of McCain and former Arizona AG, dies at 67 Super PACs release ad campaign hitting Vance over past comments on Trump Glasgow summit raises stakes for Biden deal MORE agree? Buybacks are that rare instance. 

A few months ago, Sen. Elizabeth Warren (D-Mass.) derided buybacks, saying “This is nothing but paper manipulation.” An article about Warren’s remark noted a commonly held belief that “stock repurchases do nothing to improve the quality of a business or the goods and services it produces.” These commonly held beliefs in buybacks are simply false. Here’s why.

A share repurchase most often happens when a firm goes to the stock market and buys back its shares. So, what does that look like in reality? Typically, there’s a person sitting at a computer with their brokerage account open pressing “sell,” and on the other end there’s someone within a firm’s treasury function pressing “buy” at the same time. (The real mechanics are more complicated, but the substance is not.) The seller has no idea that the net recipient of the shares they are selling is the firm. The person is simply selling their shares because they want to hold cash instead of holding the stock. The person can use this cash however they please — invest it in other companies that might have more productive investment opportunities, give it to charity, give it to their kids or whatever else they want to do with it, because, after all, it is their money. The firm is simply buying its own shares on the open market, returning cash with no greater use within the firm to its shareholders.

ADVERTISEMENT

So, does that somehow mechanically manipulate the stock price or earnings per share (EPS)? No. It is pretty easy to show that the mechanical effect of a buyback is simply to produce a smaller firm with fewer shares outstanding with the same price per share and EPS.

Let’s imagine a simple company with five shareholders, with all earnings paid out as dividends. Each shareholder contributed $1 to the firm in exchange for one share of stock, so the firm’s market value is $5. Assume the company earns a 10 percent return on its $5 of capital, so the firm generates $0.50 of earnings and $0.10 of EPS.

Now imagine the shareholders decide to have the company buy back a single share of the stock. The company takes a dollar from the corporate coffers, gives it to a shareholder in exchange for the share and rips up the repurchased share. What does this do to share price? Four shares are outstanding and there is only $4 of contributed capital, so each share is still worth a dollar. Share price was not manipulated. And what about EPS? A 10 percent return on the $4 of capital makes for $0.40 of earnings, which split four ways yields $0.10 of EPS. EPS was not manipulated. The mechanical effect of a buyback is simply to produce a smaller firm with fewer shares outstanding with the same price per share and EPS.

Is this mechanical effect what we see in real life? No, not necessarily, because firms don’t simply pay out cash that earns the same return as all of their other assets. Rather, a firm will buy back its shares with its least productive assets, meaning, on average, the remaining assets are more productive and the return may well increase.

As a result, the sentiment that buybacks “do nothing to improve the quality of a business” is false. Buybacks help the company eliminate its least productive capital, and make the company more efficient (smaller and with more productive assets, on average). If changing the composition of assets indirectly improves the firm, this may, indeed, increase earnings per share at companies and increase the value of the remaining shares.

Would the person who pressed “sell” have made their initial investment in the firm if they had known that the firm could not freely return this capital? Perhaps, but certainly not for the same price per share. Restricting a company’s ability to freely decide when it can return capital to shareholders makes capital more expensive. And who bears that cost? The very shareholders who want to give the firm their money and then eventually ask the firm to return that capital (where the “ask” is made by the person pressing “sell”).

In an effort to avoid share repurchase restrictions, firms will be incentivized to use their least productive assets for their lowest margin projects. Wouldn’t we rather firms return underutilized capital to their shareholders, who can then reinvest this money elsewhere, rather than firms blow the underutilized capital on their lowest-margin projects? 

Can companies engage in repurchases poorly? Certainly. Just as an investor can buy shares and be worse off for it, so too can companies repurchase shares and be worse off for it. But this is no reason to disparage the ability of an investor to purchase shares, or the ability of a company to return capital to investors through repurchases.

Buybacks are a simple adjustment to a company. When a company has too much cash and nothing to do with it, we should want the company to return this cash to its owners. To charge companies a 2 percent tax for doing so suggests a fundamental misunderstanding of why firms repurchase their shares. 

Jeffrey Hoopes is an associate professor and Harold Q. Langenderfer Scholar of Accounting at the University of North Carolina’s Kenan-Flagler Business School, and the research director of the UNC Tax Center. Allison Koester is the Saleh Romeih Associate Professor of Business at Georgetown University’s McDonough School of Business.