Assessing the Impact of Stock Buybacks
A stock buyback is when a company buys shares it previously issued to the market using excess cash reserves.
Free Cash Flow to Equity (FCFE) is the cash left for equity-holders after all necessary payments from the company.
Management must decide where to put the FCFE they hold. They may choose to:
- spend it on revenue-generating assets
- save it
- return the cash to the shareholders, or
- acquire businesses
This is the main area of contention: are share repurchases really the best use of FCFE?
Buybacks are primarily a phenomenon seen in the United States and, increasingly, in Japan.
The Tax Cuts and Jobs Act passed into US law in December 2017 was a major catalyst for the boom in record-breaking buyback spending seen in 2018. President Trump reduced the corporate tax rate from 35% to 21%, injecting cash into corporate America. This windfall was passed on to shareholders in the form of buybacks to the tune of $806bn, compared to $519bn in 2017 and $536.4bn in 2016.[1]
Since 2010, according to Zion Research, constituents of the S&P500 have spent $3.9tn on share repurchase programs.[2]
However, even this seemingly tireless corporate engine has been ground to a halt by the Coronavirus. With profits taking a hit, and fiscal packages banning companies from using the taxpayer’s money to pay shareholders, the buyback spending is certain to fall in 2020.
One industry notorious for buybacks is the airline industry, spending 96% of Free Cash Flow on buybacks.[3] Nevertheless, it will receive huge bailout packages from the government.
American Airlines spent $1.1bn on buybacks in 2019; it is receiving $5.8bn from the $2tn bailout package and applying for a further stimulus of around $5bn. Delta spent $1.3bn and will receive $5.4bn in grants and loans.[4]
Surely it is not fair for the taxpayer to pay more in future taxes for corporations like these. So, why do policymakers still debate the credibility of buybacks?
The main proponents of buybacks are company managements, investors and essentially anyone who supports free markets. The main arguments they put forward are as follows.
They Allow a Company To Support Its Stock Price
Mathematically, the stock price of a company is its total equity value divided by the number of shares it issues to the market.
In a buyback, the company repurchases the stock from the market and transfers them to its own books so that the total number of its shares in the market are reduced, which translates to a higher stock price, even though prevailing market sentiment was pushing the price down.
By performing the buyback, the company is able to support its stock price and protect its investors. This also has the added effect of showing potential investors that the company considers its investors’ interests which may help improve demand for their shares.
This can be very beneficial for investors during recessions when equity markets can nosedive.
Reaching an Optimal Capital Structure
Furthermore, buybacks can be seen as a method of recapitalisation.
A company’s capital consists of debt and equity. Recapitalisation is the changing of the mix between the two. Buybacks reduce equity by reducing the number of shares in the market.
Companies measure their capital structure using the Debt-to-Equity ratio. There exists an optimal D/E ratio for each firm which minimises the cost of their capital – the overall cost of raising money through both debt and equity.
So, if a firm believes that by increasing its D/E ratio it can reduce the cost of its capital then there are two ways to do it – reduce Equity or increase Debt. Buybacks do the job of the former allowing the firm greater access to fresh capital.
FCFE Belongs to Shareholders
The most controversial argument for buybacks is that shareholders should have a say in whether or not FCFE can be used for management to take on projects or not.
FCFE belongs to shareholders. Why should management decide whether or not shareholders’ money should be returned to them? As an investor, would you trust management to take on good projects?
If you _do _trust them, then you will reinvest in the company yourself.
If you don’t trust them you can sell your shares, take the cash and invest where you think your money will work hardest.
Advocates of free markets suggest that giving shareholders this option allows markets to allocate capital to the most efficient companies.
Opponents of buybacks tend to be employees, much of the middle class and those who do not believe in the efficiency of free markets. They think the following.
The Money Can Benefit Employees or the Business Itself
A case could be made that the excess cash can be better used by reinvesting into new projects or in its employees.
US unemployment rate was 11.1% [5] in June, income inequality has risen as the median household income remains stagnant.
Given these fundamental weaknesses in the American economy, diverting money to the welfare of employees would be a more effective use of cash. There are several cases from even before the virus where businesses still chose investors over employees.
For instance, Harley Davidson announced that it would be shutting its doors on 800 of its workers in Kansas City in January 2018. It then increased its dividend and planned a buyback program worth almost $700bn.[6]
Is it right to spend cash like this when there are so many unemployed?
Nowadays, we are seeing a shift towards the Environmental, Social and Governance investing space where companies are rewarding for considering these factors. A Federated Hermes survey of UK Independent Financial Advisors found that more than 85% of respondents had seen a rise in requests to re-allocate capital to ESG-related funds.[7]
Clearly, using FCFE on employees rather than investors actually makes business sense too, opposing the conventional view.
By substituting worker benefits for shareholder gluttony, corporate America is adding salt to the American economy’s wounds.
Leveraging
This is the term used for companies taking on more debt.
So far, we have considered how muchbuybacks have cost the economy however maybe we should also look at how these buyback programs have been financed.
At the start of May, Apple announced its issuance of $8.5bn worth of debt and stated that it would use part of this on its share repurchase program and increasing dividends. [8]
According to the Financial Times, $821bn of new equity has been issued to European markets between 2000 and 2017 however this is dwarfed by the $4.96tn of equity withdrawn largely in the form of buybacks.[9]
Using FCFE to repurchase shares is one thing, however leveraging the company to do so seems to be a grossly irrational concept as the debt is not used to generate sales that would help repay it in the future.
Against the backdrop of soaring corporate debt and the compounded impact of the Coronavirus, financing buybacks with debt does not seem like good management at all.
In conclusion, buybacks continue to be a contentious subject and, at least while the Republicans hold office, it’s unlikely corporate America will face substantial resistance from policymakers.
A continuation of share buybacks can exacerbate income inequality in the US and raise corporate debt levels. The money can otherwise be used to invest in the future, workers or meaningful acquisitions.
However, corporate finance principles tell us that buybacks are a useful tool in reducing the cost of capital. They help management maintain control and reward risk-taking investors as opposed to employees. And in the end, if the money belongs to shareholders, shouldn’t they decide what to do with it?
According to Informa Financial Intelligence, 1/3 of companies in the S&P500 suspended share repurchases in the first quarter of 2020.[10] Insofar as the coronavirus is concerned, buybacks may not pose a huge issue however bans on the use of bailout money for share repurchases is hardly a long-term solution.