Share Buybacks - Nothing But Paper Manipulation?
Main takeaways
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Buybacks can create or destroy shareholder value, depending on whether the stock is under- or overpriced.
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Buybacks also have a real effect on investment decisions and capital structure, which makes them much more than paper manipulation.
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Buybacks are typically not conducted at the expense of workers and consumers, they are simply a way to redirect investment from companies that don't need excess cash to those that do.
Buybacks are Breaking Bad
Although stock buybacks seem like a relatively straightforward topic in corporate finance, they have caused their fair share of controversy over the past couple of years. In May of 2023, the US House of Democrats proposed the Reward Work Act in which they attempt to rein in repurchases and possibly tax them. Representative Garcia claimed that they occur “at the expense of workers, consumers and the U.S. economy” because the money could be used to raise wages or invest in goods or services. Elizabeth Warren is also an outspoken advocate against share repurchases, claiming that they are “nothing but paper manipulation” to add some “fluff-and-buff” to the company’s stock.
Given that buybacks have experienced a meteoric rise over the past decade, this article attempts to explore the mechanics of buybacks and shed a light on their possible benefits and drawbacks.
Source: Chartr
Balance Sheet Basics
The first step towards understanding share buybacks is to analyse what is happening at the balance sheet level. As you know, said financial statement balances assets with liabilities and stockholder’s equity.
Source: OpenStax
The intuition behind this is as follows: every company is made up of a series of assets (machines, inventory, cash, etc). In order to acquire the assets, the company has to get the money from somewhere: either the owners of the corporation use their money to buy the assets (equity), or they borrow the money from somebody else (liabilities). In other words, all uses of capital (i.e. the assets bought with the money) are equated to all the sources of capital (i.e. the equity or debt used to finance the assets):
Assets = Liabilities + Stockholders Equity
Buyback Basics
Now that we’ve covered the balance sheet, let’s move onto the buyback process. Whenever share repurchases are conducted, the company is taking cash and using it to buy the stock from shareholders who are willing to sell it.
If cash is used to buy back shares, then the value of the corporation decreases. Think about it: all else equal, a business with $100k in cash is worth more than the same business with only $90k in cash.
However, the number of shares outstanding is also lower. Shares that were once held by stockholders are now possessed by the corporation. The shares bought back by the corporation are known as Treasury Stock, and they have no claim on dividends or earnings.
The business is worth less, but each shareholder owns a bigger part of it. The two offset and price remains the same. We can also put this in terms of our equation. Remember:
Assets = Liabilities + Stockholders Equity
If cash is leaving the company, the asset side of the equation is going down. In order for the two sides to remain equal, in order for them to balance, the stockholder’s equity must also decrease.
In simple terms: the pizza gets smaller, but each person gets to eat a bigger slice; so they get to eat the same amount. Hence, their ownership of the pizza is worth the same. Consequently, share repurchases in an efficient market do not create wealth, and they are certainly NOT “paper manipulation” because price remains unchanged.
Naturally, the question arises: if buybacks do not create wealth, then why do corporations engage in them? Share repurchases are a way to return cash to shareholders. The reason one buys a business is to get a claim on the cash flows produced by selling products or services. If the company is generating cash and has no way to re-invest at a higher rate of return than the investor, then the investor will want the money back. Picture a mature company that has exhausted all avenues of growth and has no use for most of the cash it produces. The money can be returned to shareholders, who will find an alternative to reinvest the money at higher rates of return. So even though it is true that the company buying back shares is investing less, once the shareholder receives the money, he can put it to work somewhere else. Consequently, buybacks do NOT come at the expense of the economy or reduce investment, they just redirect the investment from mature business sectors that have no need for the additional cash to industries that require it.
Buybacks & Share Price
As you may know, the price of the business and its intrinsic value are not the same thing. The intrinsic value is the present value of all future cash flows, while the price is simply what people are willing to buy or sell the business for. The two can be equal but are often not. The explanation from the previous section assumes that shares are fairly priced and, therefore, share repurchases do not create wealth. If a discrepancy between price and value exists, then share buybacks transfer wealth.
Let’s say the stock is overpriced (i.e. price > intrinsic value), and a buyback is conducted. The corporation is using cash to buy something for more than what it's worth. On the flip side, the shareholders who tender their shares are selling something for more than it's worth. So there is a transfer of wealth: from the shareholders who do not tender their shares and whose cash is spent to the shareholders who do tender their shares and who receive the cash. A share buyback might take place in spite of overpriced shares if management is unaware of the true intrinsic value of its business. As Buffett puts it, “If you’re repurchasing shares above a rationally calculated intrinsic value, you are harming your shareholders, just as if you issue shares beneath that figure, you are harming your shareholders”.
Now let’s turn to the case in which the stock is undervalued (i.e. price < intrinsic value). In this situation, the corporation is buying something for less than what it is worth. Conversely, the shareholders who tender their stock are getting rid of their shares for less than what they should get. Again, there is a transfer of wealth: from those who tender their shares and receive less cash than the value of what they are giving away to those who do not tender their shares. Management should be eager to buy back their stock below its intrinsic value. But why would anyone sell below intrinsic value? Shareholder who sell in this situation could have the following reasons:
- they disagree on the actual intrinsic value of the business and don’t perceive the shares as undervalued;
- they found a better investment opportunity, so they sell undervalued shares to buy stock in another company that is even more undervalued;
- the seller wishes to stop accumulating wealth and start spending, so they take advantage of the liquidity provided by the corporation.
Buybacks, Capital Structure & Investments
Elizabeth Warren also pointed out that “nothing about the business changes” when buybacks are conducted. However, share buybacks do have the potential to change a business.
The amount of debt and equity used to finance the assets, known as the capital structure, is relevant because it affects the cost of capital of the business (i.e. the required return by debtholders and shareholders) and can also influence investment decisions.
When it comes to capital structure, funding assets with debt provides a tax advantage. There are instances in which companies borrow money and use the proceeds to buy shares. This is known as a leveraged recapitalisation and will change the debt-to-equity ratio of the company. Long story short: buybacks can create tax advantages for a business, or they can bring it closer to distress if leverage is not managed properly. For example, prior to COVID, Southwest Airlines used substantial cash to conduct buybacks, only to find itself asking for a government rescue a couple of months later. Hence, they can have a very real impact on the firm’s financing.
As for investment decisions, if management has access to excess cash, they might spend it on unnecessary acquisitions or dumb projects. Returning the cash to shareholders reduces the opportunities for management to engage in wasteful spending. On the other hand, if the cash could be used for a better investment opportunity, then returning it to shareholders will diminish value if no other financing sources are available.
Additionally, buybacks can be used as short-term band aids. If management is looking to boost EPS or hit guidance targets, cash could be wasted on buybacks instead of directed towards positive NPV projects. Using buybacks to boost EPS is bound to fail in the long-term, as the firm is not improving its operations in any way. Whenever management runs out of excess cash, they will be forced to focus on increasing revenues or reducing costs to meet EPS targets.
Buybacks Are NOT Paper Manipulation
Overall, it is safe to say that buybacks can have a real impact on both the corporation and the investor’s portfolio. From the corporation’s perspective, buybacks can affect investing decisions, create tax advantages through changes in capital structure, bring a firm close to distress or be a tool to boost short-term earnings. As for the investors, depending on whether the stock is over- or underpriced, repurchases can create or destroy value. While proposals to tax buybacks have no solid theoretical backing and are better kept as a thought experiment, buybacks do have drawbacks if used improperly.
If you are curious and want to learn more, you can check out this FSG article by Pieter Kraak. Alternatively, this Financial Times interview explores the recent growth in buybacks in more detail, along with examples of companies that have recently misused share repurchases.
