How Companies Pay Shareholders: Buybacks Are Not A Giveaway
London Business School finance professor Alex Edmans devotes a substantial portion of his excellent book Grow the Pie to stock buybacks. His discussion offers an honest recapitulation of both the political and financial case against them, showing that he has taken that point of view seriously. He then describes what buybacks actually are and what they do, in order to get people oriented around an accurate understanding of the fact pattern. Then he offers a partial defense of stock buybacks, with some suggestions for dealing with the particular situations in which buybacks shrink, rather than grow, the pie.
I’ll familiarize the reader with his arguments and interact with them in several stages.
The standard horror story about stock buybacks is the story of Humana in 2014. The CEO of Humana had a compensation package which strongly incentivized him to hit a certain earnings per share (EPS) number. If he could hit $7.50 per share, he got his bonus.
The CEO initially engaged in a standard earnings shenanigans move: classifying an expense which is reasonably likely to continue to occur as a non-recurring item. By doing that, the expense is not used to calculate the earnings portion of EPS. But even after that, he was still short a few pennies, so he launched a large stock-buyback program. The math is simple. EPS is earnings divided by the outstanding shares. If you decrease the number of shares outstanding, you shrink the denominator without changing the numerator (since buybacks are not treated as an expense), raising the ratio. He hit his target, got his bonus, (despite Humana having been an underperformer) and added credence to the idea that share buybacks are basically just a way to game the system.
Edmans acknowledges the problem:
“But buybacks allow the leader to meet an EPS target artificially without actually raising firm performance, because they lower the number of shares outstanding…”
As a result of anecdotes like this and a serious dearth of financial literacy among politicians, buybacks became a political whipping boy.
“…politicians – surprisingly, from both sides of the political spectrum – are calling for restrictions on buybacks. In February 2019, Democratic Senators Chuck Schumer and Bernie Sanders published a plan to limit share repurchases, and a week later Republican Senator Marco Rubio announced his own proposal.”
Edmans differs from this bipartisan consensus, going on to argue,
“[…] that pie-growing enterprises should engage in far fewer buybacks than those that practise ESV. But I’ll also stress that, properly executed, buybacks can grow the pie. Of course, the critical words are ‘properly executed’ and ‘can’. So we’ll use large-scale evidence to show that, in most – but not all – cases, buybacks do create value.”
One of the root problems with anti-buyback fervor is a simple lack of understanding about what buybacks are. Critics treat them as some sort of ‘gimme’, an undeserved gift, a windfall for investors.
“But buybacks aren’t a freebie where investors get something for nothing. Investors do get cash, but only in return for giving up their shares.”
— Alex Edmans, Grow the Pie
When investors buy shares, they give up cash to gain future claims on the companies they invest in. They buy something. Well, when companies buy those shares back, they are spending money to get the investors to give up those claims. They get something for their money.
Think about borrowing money from a bank. The bank ‘gives’ you money and in exchange they have a claim on you to pay them interest and eventually a return of the principle. If you pay off the loan, you reverse that transaction. You ‘buy back’ the piece of paper from them. Edmans says:
“This is like how an enterprise repaying debt gives cash to the bank today, in exchange for reducing the bank’s future claim on the firm – and few would argue that repaying debt is a free gift to the bank.”
Originally published on Townhall Finance.
Jerry Bowyer is a Forbes contributor, contributing editor of AffluentInvestor.com, and Senior Fellow in Business Economics at The Center for Cultural Leadership.
Jerry has compiled an impressive record as a leading thinker in finance and economics. He worked as an auditor and a tax consultant with Arthur Anderson, as Vice President of the Beechwood Company which is the family office associated with Federated Investors, and has consulted in various privatization efforts for Allegheny County, Pennsylvania. He founded the influential economic think tank, the Allegheny Institute, and has lectured extensively at universities, businesses and civic groups.
Jerry has been a member of three investment committees, among which is Benchmark Financial, Pittsburgh’s largest financial services firm. Jerry had been a regular commentator on Fox Business News and Fox News. He was formerly a CNBC Contributor, has guest-hosted “The Kudlow Report”, and has written for CNBC.com, National Review Online, and The Wall Street Journal, as well as many other publications. He is the author of The Bush Boom and more recently The Free Market Capitalist’s Survival Guide, published by HarperCollins. Jerry is the President of Bowyer Research.
Jerry consulted extensively with the Bush White House on matters pertaining to the recent economic crisis. He has been quoted in the New York Times, The Wall Street Journal, Forbes Magazine, The International Herald Tribune and various local newspapers. He has been a contributing editor of National Review Online, The New York Sun and Townhall Magazine. Jerry has hosted daily radio and TV programs and was one of the founding members of WQED’s On-Q Friday Roundtable. He has guest-hosted the Bill Bennett radio program as well as radio programs in Chicago, Dallas and Los Angeles.
Jerry is the former host of WorldView, a nationally syndicated Sunday-morning political talk show created on the model of Meet The Press. On WorldView, Jerry interviewed distinguished guests including the Vice President, Treasury Secretary, HUD Secretary, former Secretary of Sate Condoleezza Rice, former Presidential Advisor Carl Rove, former Attorney General Edwin Meese and publisher Steve Forbes.
Jerry has taught social ethics at Ottawa Theological Hall, public policy at Saint Vincent’s College, and guest lectured at Carnegie Mellon’s graduate Heinz School of Public Policy. In 1997 Jerry gave the commencement address at his alma mater, Robert Morris University. He was the youngest speaker in the history of the school, and the school received more requests for transcripts of Jerry’s speech than at any other time in its 120-year history.
Jerry lives in Pennsylvania with his wife, Susan, and the youngest three of their seven children.
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