“Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies.” Groucho Marx
I wonder if there is a more applicable case of Marx’s quote in 2020 than the topic of corporate stock buybacks within the US political echo-chamber. Here is an interesting article from 2019 on the topic. I wish I had a nickel for each time I heard an analyst observe that the primary rationale for increased stock valuation and growth in the S&P 500 is the increasing rate of corporate buy-backs. The logic presented goes something like this: companies earn $x millions per quarter, which translates to $x.xx earnings per share (EPS); By going to the market and repurchasing their own shares, the business is thus able to reduce the number of shares outstanding, and inflate EPS from $x.xx to a greater value.
This appears reasonably logical. During this period of increasing inequality, when rhetorically matching this criticism with details about the rate at which wealthier Americans own a disproportionate share of publicly traded stocks, it seems sophisticated to attack corporate share repurchases as a means to increasing wealth concentration. (For background on some popular views of the topic of trends in inequality, but not specifically about buybacks, read this summary of Thomas Piketty’s work here.) This analysis of how buybacks impact valuation is erroneous, though [1]. The error is rooted in the omission of details of the “trade” of cash for stock.
In looking for some notes to reference, I came across this very nice summary of Modigliani-Miller’s work in indifference theory on the site of a faculty member at Haas at UC Berkeley. (Yes, assumptions about friction and taxes matter in real life. I know.) The key insight is that one should connect the left side of the balance sheet to market values, and view the difference between book value (BV) and market value (MV) as the anticipated synergy created by the real combination of assets and capabilities, whereas the right side of the balance sheet reflects financing decisions. Share buybacks reside on the right side of the balance sheet in the sense that they impact the capital structure of the business.
Take the example of an unlevered firm. A trade of cash for equity, where the equity is, in economic terms, worth what the firm paid for it is an economic non-event, except to the extent that it reduces the firms liquidity (i.e. cash position). On the other hand, if a firm engages in this transaction and pays (i.e. reduces cash) by $1 and receives stock with an economic value greater than $1, the firm has created value for remaining shareholders; Vice versa, if the stock is not worth $1, the firm has destroyed value.
When a company repurchases stock, the convention is typically to account by crediting Cash the amount of the purchase and debiting Treasury Stock, which is a contra-equity account. The consequence is, from a book value perspective, a trade occurs that leads to a smaller firm (i.e. fewer assets). In a levered context, because the firm’s liabilities are unchanged, this also leads to an increase in debt-to-equity. This is little more than a change in capital structure policy.
Aside: The AICPA has leaders engaged in debate about whether the accounting for buybacks should be changed. For example, in this opinion the following is mentioned:
It is illogical for third-party, publicly traded stock to be recorded at its fair market value, but publicly traded treasury stock recorded only at cost. Fair market value pricing for both is readily available, and marking treasury stock to market is an important way to evaluate management’s premise that the company’s stock is undervalued. With today’s high price of common stock, the probability is that many companies will buy back their stock at a higher price than will exist in the future. They will continue to do so as long as there is no accounting for the loss to shareholders caused by overpaying for the company’s stock.
The Big Accounting Hole, November, 2018, The CPA Journal
Let’s look at an example. Apple is frequently cited as an example of a firm that engages in buybacks. Here is an article from Bloomberg on April 30, 2020 on this topic. Specifically:
Few topics in the market get emotions running as hot as repurchases. Their impact on everything from stock prices and per-share earnings to the fabric of society are spiritedly debated, with easy answers elusive. Critics see them as financial engineering, juicing executive compensation in lieu of investments elsewhere. Others say the impact is overstated: using cash to repurchase shares is just a value-neutral exchange of assets from one pocket to another, with little ability to increase overall wealth.
Apple bumped up its program by $50 billion as it reported a 1% revenue jump in the January-to-March period. It also raised its dividend by 5 cents to 82 cents. Apple had $40.2 billion in cash equivalents in the quarter, slightly less than the same time a year ago but up from the previous quarter.
Buybacks Still On at Apple, Alphabet With Tech Giants Flush, April 30, 2020, Bloomberg
How does this translate directly into the Apple financials? Here is the most recent 10Q, including results for the quarter ending 3/28/20. Diluted shares (‘000s) outstanding decreased compared to the comparable Q1,’19 period from 4,700,646 to 4,404,691. While net income (‘millions) decreased from $11,561 to $11,249, diluted EPS increased from $2.46 to $2.55. Common stock repurchased (‘millions) is reflected in Q1,’20 retained earnings as ($18,516). Finally, the cash position of Apple at the end of Q1,’20 was $43,049, compared with its starting position of $50,224 (six months earlier). According to the Statement of Cash Flows, $39,280 was used to repurchase common stock.
Is Apple better off as a result of this? I don’t know. I own $AAPL directly, so I do hope so! But, my rationale for holding the position is that a) Apple has assets and capabilities that create economic value today, b) there are obstacles for other firms to erode Apple’s position in the market, and c) the firm has a strong leadership team that will manage the position of the firm, and its resources, effectively. The decision to continue stock repurchases is a small aspect of item ‘c’, along with dividend policy, rather than a major value driver, such as decisions around the firm’s supply-chain, marketing expenditures, and investments into wearables, healthcare, and new technologies. If Apple’s average cost per repurchased share was $285 over the past six months, and the market is presently valuing Apple at $289.07, it isn’t obvious to me that this a “free lunch” for remaining shareholders of Apple. Perhaps it should signal that Apple feels this is the optimal use of cash balances, and it cannot identify better projects to which it can deploy the resources.
If you would be interested in an example of stock buybacks destroying value for shareholders, I would point no further than Bang and Olufsen’s behavior during 2018. Here is a post I wrote about B&O.
Perhaps the most succinct analysis of the ethics of stock buybacks in corporate finance comes from Warren Buffett. He was quoted yesterday, at the Berkshire annual meeting, as “indicating that companies should buy back shares if the stock is trading below intrinsic value. He also acknowledged that companies will make mistakes in buying back shares, but it should be a guiding principle.”
I would be remiss in failing to clearly acknowledge entirely appropriate criticism of management decisions to engage in buybacks. Again, please read my critique of B&O. When executive compensation is tied to EPS, and malincentives are not managed, that is an issue; This is an issue of poor incentive design, not an example of buybacks being fundamentally exploitative. Where higher rates of leverage can amplify returns to equity in periods of growth, there is no free lunch, and those risks must be managed; The issue is one of capital structure targets, not one of stock buybacks as a tool to affect capital structure. Ultimately, these are important issues of corporate governance, and should be focal points for every firm’s BOD.
Typically, when presented with quotes from Marx in the context of arguments of social issues arising from growing inequality, the reference is to Karl. I ask that the next time such an argument is made around the aggravating influence of stock buybacks on social stability and fairness, let’s keep in mind the words of Groucho. We should not try to solve these particular societal issues by impeding firms’ ability to deploy simple financial policy levers.
[1] Formulaically, there should be value created when adding debt to an unlevered firm’s capital structure as a result of the present value of future cash flow benefits resulting from the interest tax shield. This idea and model is written about extensively.