Share Buybacks: The Scapegoat of Ineffective Policy
What are share buybacks, how are they different than dividends, and why they are not the culprit of growing inequality
Disclaimer: I am in no way an expert on this topic. The purpose of this article is to share my perspective and create a dialogue on the topic of share buybacks. If you find flaws or fallacies in my article, I’d love to hear your perspective!
The Basics of Share Buybacks
What are Share Buybacks?
Share buybacks are exactly what is implied by the name: companies buy back their stock. This method of capital allocation is a way for companies to return value to investors, and will usually occur when a company feels as though there is no alternative investment that they can make that would make the company better off. By reducing the number of outstanding shares, each share represents a larger portion of the company and thus is worth more (this is because subsequently if earnings stay the same, EPS will be higher for instance).
Share buybacks and dividends fall into a similar category of capital allocation: they are companies' way of returning value to shareholders. When making allocation decisions, R&D projects, internal growth projects, and acquisitions, among other things, will be looked at to see if there is a way to generate growth for the company. If there is nothing available to improve the long term value of the company, they often will return earnings to shareholders directly.
Where buybacks and dividends differentiate is in how they deliver value. Share buybacks provide capital gains to investors by raising the value of the shares, whereas dividends provide cash directly to investors. They both do the same thing, just in different ways, and with different consequences.
What are the flaws of Buybacks?
As with anything in finance, there are many flaws when it comes to buybacks, and I will list a few of them, before looking at them more closely later in the article.
- They provide wealth to already rich individuals, not passing down earnings to employees.
- Critics call it “financial engineering” that does nothing to improve American businesses
- Artificial rises in stock prices can mask underlying problems in companies
- Executives are compensated through stock-based pay, meaning they stand directly to gain from the buybacks
What’s the difference between Dividends and Share Buybacks?
Taxation disparities: The first thing that favors buybacks is tax rates. Dividends are taxed as income, while capital gains have their own tax rates. Interestingly enough, capital gains taxes are considerably lower than income taxes, and capital gains are only paid when a gain is realized, meaning the tax is deferred until the asset is sold (note: I am referring to the class capital gains taxes that apply after holding an asset for more than a year). This is a point Warren Buffet has made in the past.
Senator Marco Rubio (R-FL) has in the past suggested raising or changing capital gains taxes to even out the taxation disparity between dividends and buybacks, though he had little success.
The Importance of Share Valuation: In a situation where management has decided to allocate capital to shareholders, considering the stock price is incredibly important. If management believes the shares are undervalued, buying back shares at the lower price can be a great way to yield returns for investors — this is a key philosophy of Warren Buffet and Charlie Munger. On the other hand, if share prices are over or fairly valued, dividends might be the better route to take, because they provide income directly to investors.
Let’s Look Closer at the Downsides of Buybacks.
Redistributing wealth to investors, instead of the workers:
This is a classic argument that is interestingly applied to share buybacks and not dividends, even though they both are doing this exact thing. In a New York Time’s article co-authored by Bernie Sanders (D-VT) and Chuck Schumer (D-NY) there is a quote:
While this point makes moral sense, it doesn’t make economic sense. It does not consider who the company is representing: its shareholders. If a decision is not profitable for the company, they should not be making that decision. Instead, Walmart decided to return some of its success to shareholders, which it likely saw as the most effective way to allocate excess capital. In a capitalist society, this is how things work… it is no longer capitalism if, within reason, corporations stop acting in the name of shareholders.
Another point that is pertinent in this specific discussion is that Walmart paid out 12 billion dollars in dividends to shareholders last year. As was alluded to above, the two things do exactly the same thing when it comes to workers vs. wealthy investors. So why aren’t dividends given the same scrutiny as buybacks? One notion is that politically it is much easier to attack something that drives up a price, instead of something putting money in people's hands, especially for retired people. My point here is that in the context of this argument, dividends and buybacks do the same thing. If you don’t like one, you, by nature, logically wouldn’t like the other. If companies can use neither to distribute wealth to investors, why would anyone want to invest? To have a system like that would undermine the entire capitalist structure.
Buybacks do nothing to spur business growth nor the economy:
This statement, in my opinion, is more or less correct. Buybacks do not reinvest to create innovation and do not result in wage increases nor creating jobs. In fact, they are often the product either of CEOs in well-established businesses seeing little opportunity for growth projects or businesses feeling skeptical about the economy. Either way, it seems irrational that any government or political actor could better determine what is best for a business then, well, the financial managers of the business.
Another interesting commentary on this point is the idea that because businesses receive government support they shouldn’t be using that to pay investors. This absolutely makes sense — there is no reason that taxpayer dollars should be funneled directly to investors. But this leads back to smart policy. For instance, take President Trump’s tax cuts. What was meant to be a way of driving the economy forward has largely been used to offer buybacks like those at Walmart, among many others. Why businesses that already had nowhere to reinvest capital needed to be given more money from the government eludes me. Instead of blaming the corporations for doing the smart thing for shareholders, government actor’s decision making should be questioned (universally, regardless of party).
To expand on my previous point, I think it is key that the government gets involved only when necessary, and puts stringent requirements on the funding it gives out. Every source will offer different numbers on the cost of the 2008 bailouts. MIT estimates it cost taxpayers roughly 498 billion dollars (most of which involved purchasing Fannie Mae and Freddie Mac). As time has gone on, however, trillions of dollars have gone to shareholders and executives, with taxpayers footing the bill — but you cannot place blame on corporations for this. Using that money, they have created tens of millions of jobs and have prospered to the point that they have no productive use for the capital they’ve created. In other words, they did their job, but there were no rules in place to ensure the government eventually got the entirety of its fair share and more: this is where the problem occurs (whether or not the government should get involved at all is another debate for another day). My main thought here is that if you give someone 100 bucks and say use this to survive and prosper, you cannot turn around in 5 years if that 100 has become 10,000 and try and control what they do with what is now their money.
Conclusion
Overall, I am not saying share buybacks are good in all situations. For instance, using buybacks to cover up poor financials, or trading based on buybacks is, to me, market manipulation. I am also not suggesting taxpayer money should be going to the wealthy few, but rather that when that happens, the error was likely made by government expenditures and not the nature of the buybacks themselves. Secondly, I suggest when people see articles that talk negatively about buybacks without mentioning dividends, that they take it with a grain of salt because they are essentially doing the same thing. Finally, when governments mention that businesses are “wasting money” by giving buybacks, remember who the real corporate finance experts are.
I hope this article has provided some unbiased background on buybacks (the first part) and that my then personal perspective sparked some thought about this topic. As I mentioned above, I would love to hear your views on this topic!
