This month we are looking into the increasingly common, seemingly innocent but potentially contentious notion of share buybacks. In simplest terms, this is when a company takes excess cash left at the end of the year and buys back its own shares on the public market.
Share buybacks are reaching record highs in terms of capital allocation and in some instances the dollar amounts are staggering. Companies are spending vast quantities of capital on their own shares sometimes dwarfing resources injected into research and development. The subject has been recently politicized in senatorial and presidential campaigns alike and will continue to spark debate. In this column, we will look closer at the history and both the good and the bad associated with this practice.
A Refresher on Ownership and the Basics of the Buyback
Implicit to this discussion is the notion of ownership as it relates to public companies; remember that shareholders are the owners of the companies traded on the public markets. Each individual share represents an actual piece of the company and carries voting rights. The number of shares for any given company outstanding on the public market is known as the float. When a company buys back the shares they themselves issued they do not hold them in a trading account like you or I would, they retire them. This is to say they decrease the size of the float by the volume purchased.
The net effect of this transaction is to relatively increase the proportional ownership associated with each share. There are also benefits to common analytic ratios we have discussed in the past, including share price, the price to earnings ratio, and the earnings per share (EPS).
In order to consolidate the concept, let’s simplify the transaction and work through an example. Imagine that a company has 10 shares outstanding on the public market trading at US$10 each and decides to buy back 2. The market capitalization prior to the purchase is the shares times share price or US$100. After the transaction, there has been no change in market capitalization but the proportionate value of each share has increased from 10% to 12.5%. There is no change in the absolute dollar value of the share but is relative value has increased.
The Good: Money to Shareholders
It can be argued that a share buyback is beneficial to shareholders. When a company is left with extra cash they need to make decisions on how to allocate these funds. Should it go toward research and development, infrastructure investment, or acquisitions? Alternatively, should the company share the profits with shareholders or its owners? Many shareholders would argue this is an excellent choice if there is no obvious place to put the capital toward growing the business and increasing the value of the company.
The company has 2 options when it comes to putting cash in the hands of its shareholders: paying out a dividend or repurchasing shares. Paying a dividend results in cash in hand but comes with a catch: tax. If the company chooses to allocate cash as a dividend, the shareholder will lose a good chunk to the government in the form of tax. If the company buys back shares and decreases the float, the relative value of a share increases; the stock price goes up. The gratification may be delayed but so is taxation. Ultimately the shareholder will pay capital gains but only when they sell the share for profit. So, what’s the problem? That sounds like a good deal to me. Read on.
Timing the Buyback
Buybacks make great sense if the share price is undervalued. And who better to understand the true value of a stock then management or the CEO? If management feels the shares of the company are trading at a discount, then a share buyback is a double win for the shareholder. Imagine a share is trading at US$50 but the management feels the true value of the stock is US$100. Not only does the shareholder defer income but the company makes an investment with exceptional returns increasing the value of the company and increasing the opportunities the company has to grow the business with the profit they reap.
You may be thinking this sounds a little like insider trading and you’re not alone in that thought. In fact, the laws had to be changed in the mid-1980s in order to permit buybacks. Prior to these changes, a company could be charged with share price manipulation.
It is both legal and a great idea but only when the company trades at a discount. The market is currently frothy. Price to earnings ratios as we’ve discussed in the past are at record highs. The entire market is trading at a premium but buybacks are reaching record highs. There is no way to argue that the rise in prices we are witnessing today will continue on without a correction. When stocks correct, the company who has spent sometimes billions on buybacks will see the value of that investment wiped out. Then why would management choose this option?
The Darker Side of Share Buybacks
Every quarter publicly traded companies release quarterly reports. The capability of the CEO and management team is judged by analysts who review these figures and report on successes and failures. Financial analysts and institutional investors use these figures to make trade decisions; they are most concerned with the short-term horizon as they must answer to those they purchase on behalf of and those they advise. Quarterly EPS are an important metric for these individuals when it comes to evaluating the success of the management team.
When the number of shares outstanding decreases, the EPS rises and management gets a better report card. If the company’s earnings fall as the number of shares fall, the effect is to buffer the drop in EPS. Imagine a company earning US$100 in the first quarter with 10 shares outstanding and an EPS of 10. Now imagine the same company buys back 2 shares in the second quarter leaving 8 outstanding on the market. The second quarter EPS increase to 12.5 (100/8). The earnings for the company are unchanged but the EPS has increased by 25% as a result of the buyback.
We can run the math in the opposite direction and see the buffering effect. The same company with 10 shares outstanding earns only US$90 in the second quarter or realizes a 10%drop since the first. If they buy back the same 2 shares decreasing the shares outstanding to 8, the EPS comes out to 11.25 (90/8). Despite a 10%fall in total earnings the buyback results in an 11.25% increase in EPS.
And while you might say this is just trickery and easy to spot that’s only case if you know where and how to look. Most don’t. Add to this sleight of hand the fact that management and CEOs may find salaries and bonuses tied to these metrics and they have more incentive to gloss over the truth. Compound this with the fact that bonuses may come in the form of share options—the option to buy a given share at a particular strike price—and it’s no surprise few take the extra time to clarify the fine print. This is not to suggest that management is nefarious but it is difficult to imagine pushing yourself under the bus when there is a way to pull yourself off the side of the road.
The Economic Implications of Buybacks
While this may seem like a small entity, there are those who believe this practice has serious implications for progress and the greater economy. There was a shift in thinking in the mid-1980s. Early on in the decade, it was felt that companies increased their value by investing in the business and their employees. A philosophical change in focus during the Regan era reset the corporate definition of success. Instead of enriching the lives of employees and society in general through the investment of corporate profits, companies began to believe that increasing shareholder value was their ultimate goal. Redirecting corporate profits into the hands of shareholders gave rise to beginnings of buybacks.
It’s hard to argue with the figures some of which are staggering. The proportion of profit funneled into buybacks in the tech and pharmaceutical sectors at times dwarf the money spent on research and development. Take apple as an example who have paid some US$325 billion back to shareholders in the last decade while only spending about US$50 billion on research and development.
The phenomenon has actually become a presidential campaign issue for the democrats so we are likely to hear more about this in the upcoming year. Elizabeth Warren, Bernie Sanders, Hilary Clinton, and Marco Rubio have all touched on this theme in their push to equalize disparity between the well to do and the middle class. The argument made is that the current approach to cash disbursement is stealing prosperity from the workforce and society at large. Whether it’s a source of malcontent or one of appreciation will depend on how many shares you own.