The Stock Buyback Decision with a Market at All-Time Highs
During the first quarter of 2018, U.S. public companies announced a record $241 billion in stock repurchases. That record lasted for all of three months, until the second quarter of 2018, with a near doubling to $436 billion of announced stock buybacks.
Since the passage of the Tax Cuts and Jobs Act of 2017, investors have sought clues into how corporations will allocate their significant tax savings. Capital spending priorities range from paying down corporate debt, investing in future growth (capex, R&D, target M&A), and returning cash to shareholders. Generally, there are two ways that public companies can return cash to shareholders – by paying dividends and by buying back their shares. Often, companies employ a combination of these two actions.
Shortly after the new law took effect, companies like Proctor and Gamble and Amgen announced new stock repurchase programs that they specifically attributed to the new tax law. Notably, Cisco announced that it planned to repurchase its entire authorization of $31 billion during the next 6-8 quarters, which amounts to 15% of the company’s market cap.
Do you see a trend here?
“The reason these companies are buying their stock is that they’re smart enough to know that it’s better for them than anything else,” said Charlie Munger, vice chairman of Berkshire Hathaway, at the company’s annual meeting in May.
Pursuant to these corporate actions, this note focuses on the fundamental drivers guiding CFO’s and corporate treasurers to opt for stock repurchases, even with the stock market trading at all-time highs, as the best way to generate high returns on their company’s invested capital.
The Issue of Market Timing
Different companies have different motivations for repurchasing their shares. One company’s motivation may be to use them for the exercise of stock options, while another firm may be repurchasing because it feels its shares are underpriced and represent a good investment. With the S&P 500 trading near all-time highs, it seems increasingly difficult to find value in the stock market. Additionally, with profit margins at record highs for many corporations, companies simply can’t invest all the excess capital into the future of their business. The problem is not having a place to invest the money, but that by issuing buybacks management is stating that an investment into the business and innovation, as well as returning cash in the form of dividends, does not bring about the same return on investment.
Buybacks benefit stockholders in two ways. First, by decreasing the number of shares outstanding, they increase the purchasing company’s earnings per share. As earnings per share increase, the price of the stock generally rises. This increases the value of the shareholders’ current holdings without requiring any additional investment and without the taxes that would be incurred if the company had paid the same money out as dividends. However, critics of stock buyback point to evidence of executives using buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity.
Second, stock buybacks provide shareholders with a margin of support under their stock by stepping in and buying shares when their stock price declines. This often causes shares to rebound faster after the market correction, as there are fewer shares available when demand returns.
Naysayers of stock buybacks claim corporations are not particularly price sensitive, and that companies tend to buy and sell their own stock at the wrong times. Historically, companies do buy more shares as markets rise and fewer shares as they fall. While these companies appear unproficient at timing the stock market, this probably has more to do with the fact that they have more capital to deploy at peaks in the business cycle than they do during the downturns. Such is the case in 2018, when a rapidly expanding economy is further fueled with a huge corporate tax cut.
The Opportunity Cost of Holding Too Much Cash
Prior to December’s tax cut, there was plenty of evidence indicating that there was no shortage of cash in corporate coffers. During 2007-16, cash balances at S&P 500 firms rose by 50%, reaching around $4 trillion, providing ample dry powder for additional expenditures.
Nonetheless, there is a substantial opportunity cost to holding on to cash or investing it in Treasury bills paying a modest interest rate. If shareholders of XYZ, Inc. can earn a 10% return on their investments and XYZ, Inc. has $100 million invested in Treasury bills paying 2%, the opportunity cost is 8%, or $8 million a year. The economic value added is negative $8 million a year, which means XYZ, Inc. is destroying value instead of creating value.
Companies could use their cash bounty to pay off all, or a portion, of their borrowings. However, U.S. tax laws reward companies that have debt. Corporate debt is a tax shield because, unlike dividends, the interest is tax-deductible (with limitations due to Trump’s tax plan–the new tax act limits interest deductibility to 30% of EBITDA). A company pays less in taxes if it is financed partly by debt instead of entirely by equity. The less that is paid in taxes, the more cash is available for bondholders and stockholders.
The Decision to Repurchase Shares
For firms that want to disburse some of their profits to shareholders, share repurchases can be better than dividends. And that is how some view stock buybacks; a dividend derivative.
Let’s return to the example of XYZ, Inc. Instead of giving $100 million to shareholders in the form of a dividend, XYZ decides to spend $100 million in a share buyback program. Either way, the value of XYZ after it gives $100 million to its shareholders is exactly the same—the same assets, the same products, the same customers whether it is a dividend or a buyback— so the aggregate value of its stock should be the same, too. The only real difference is that the taxes shareholders pay on the $100 million they receive depends on whether it is called a dividend or a buyback.
The Value of a Stock Repurchase Program
The real value of a buyback comes from the disbursement of idle cash, not from a change in the number of shares. Let’s ignore taxes and work through a simple example. XYZ, Inc. has 20 million shares outstanding, each valued at $20 (an aggregate market value of $400 million). This firm has $20 million in cash to distribute to its shareholders. One alternative is to pay a $1 dividend per share; another is to buy back 1 million shares at $20 apiece. This table shows the consequences. Either way, the $20 million payout reduces the firm’s aggregate value from $400 million to $380 million.
If XYZ pays a $1 dividend, each share is worth $1 less, since $380 million divided among 20 million shares is $19. The shareholders are no better or worse off since they started with $400 million in stock and now they have $20 million in cash and $380 million in stock.
If, instead, XYZ repurchases shares, the number of shares declines by 1 million, and $380 million aggregate value divided among 19 million shares makes each share worth $20. No one is better or worse off. Those who sell their shares get $20 in cash for their stock; those who don’t sell continue to have stock worth $20 a share.
Stock Buybacks vs. Dividends
Dividends and buybacks are alternative ways of giving a firm’s shareholders some of the profits that the firm earns on their behalf. The crucial difference between dividends and buybacks is the tax consequences for shareholders, and this gives buybacks a clear advantage over dividends.
When a company pays dividends, all shareholders pay taxes, and they pay taxes on all the cash they receive. When a company repurchases stock, shareholders don’t have to sell, and those who do sell only pay taxes on their capital gains. That may not be all of them. Some may have no capital gains and pay no taxes; others may have tax losses and receive a tax credit. The bottom line is that with buybacks, shareholders have a choice: to sell or not. Those who do sell don’t have to pay as much in taxes as they would if the firm had disbursed the cash as dividends.
The other reason buybacks are popular is dividends require investors to reinvest the cash if they want to keep their stake in the company, while buybacks don’t require anything to be done. Moreover, buybacks allow taxes to be deferred while dividends are taxed the moment they are paid out. That’s very inefficient and destroys capital with undo tax payments if you plan to reinvest the dividends anyway.
However, some critics argue that an issue for stock repurchases, unlike dividends, can be used to systematically transfer value from shareholders to executives. Researchers have shown that executives opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses.
Long Term Implications
A company’s goal for a significant buyback program is to have a long-term beneficial impact on its shareholders. In the best of all situations, the company is generating enough cash to buy back its stock without sacrificing research and development, marketing, expansion plans, or dividends. In other words, a strong buyback situation is one in which the purchases are funded from excess cash flow.
The question of share issuance also needs to be addressed. It is entirely possible for a company to repurchase shares and still have its total share count increase. This occurs when the shares being issued to satisfy outstanding stock options are greater than the number of
shares being repurchased. This situation is not necessarily a negative, since it is transferring owner ship from the public to insiders and employees of the company. Additionally, shareholders in such a company are clearly diluted less by stock options than would have been the case had the company not repurchased any shares. These repurchase programs should not be entirely ruled out, but those that result in an actual decrease in shares outstanding are clearly more beneficial to shareholders
Share buybacks in 2018 have so far averaged $4.8 billion per day, double the pace from the same period last year. Some have argued that all that buying insulates the market against drops, which causes volatility to drop. “Stock buybacks are in effect creating low volatility,” says Christopher Cole, a hedge fund manager who has been warning that volatility has been artificially and dangerously depressed for a while. “Share buybacks are like a giant synthetic short-volatility position.”
 “Tax Cut Triggers $437 Billion Explosion of Stock Buybacks,” CNN.com, July 10, 2018
 “What Do Share Buybacks Really Tell Us About the Stock Market?” A Wealth of Common Sense, April 5, 2016
 “Corporate stock buybacks are booming, thanks to the Republican tax cuts,” Vox.com, March 22, 2018.
 “Add Stock Buybacks to the Causes of the Market Downturn,” Bloomberg, February 16, 2018