As a shareholder, you do want to know if all these share buy backs create value for you (and me) …
This is a follow-up post after my post Number of Shares Outstanding, explaining the nature of share buy backs or SBBs and their economic effects for shareholders.
Some media reports, i.e. this and this, suggest that more and more companies, especially in the US, used historically low borrowing costs to borrow money using it to fund share buy backs (SBBs). This story will be retold many times now, since the same companies get government bailouts during the corona crisis. It is fair to assume, that these SBBs drove the companys share prices higher and increased earnings per share (EpS) that could be good for executives with their share options and other incentives linked to price-per-share… With this line of thoughts, I think it is time to revisit the economic rational of stock buy backs.
Prof. Damodaran writes HERE that …
… managers who are compensated with options may find it in their best interests to buy back stock rather than pay dividends; the former pushes up stock prices while the latter lowers them. … I agree that there is a problem, but buybacks are again a symptom, not a cause of the problem. In my view, it is poor corporate governance practice on the part of boards of directors to grant huge option packages to managers and then vote for buybacks designed to make managers even better off. Again, fixing buybacks does nothing to solve the underlying problem.
If not stated otherwise, I will always
take the view of a longterm shareholder who does not sell shares,
even if the company is buying them own back.
What to do with Excess Cash?
If companies have too much excess cash, they have to decide what to do with it. These are the general options
- reinvest into the business
- pay dividends to shareholders
- buy back own shares
- acquiring other businesses
- repaying debt
- hoarding cash
Reinvesting cash into the business obviously depends on opportunities to put that cash to use. Upgrading machinery only to cleans the balance sheet of all that excess cash, via any kind of expenses or long term investments (CapEx), is not a good way to spend it per se. It very much depends on the alternatives and their risk adjusted returns. Anything else equal, raising salaries does not create shareholder value either.
Dividends might be a good way to return cash directly to shareholders if their are no obvious alternative uses. But cash dividends are usually taxed at the investors level as capital income (above a certain annual threshold).
Buying back shares is another (even more tax effective) way to return cash to shareholders. If shares are undervalued it can strongly increase long term shareholder returns.
Acquisitions of other businesses are comparable to buying machinery (spend the cash as capex), but their are common flaws involved. The acquirer overpays quite often. Synergies are overestimated, by miscalculation or for empire building purposes. Integration does not go smoothly and cultural issues are underestimated. Management might loose sight of more relevant topic.
Repaying debt lowers cash and gross financial debt (and future interest payments) and it changes the risks profile of the company.
Hoarding cash is another option. It derisks the company (further) and enables the company to use it opportunistically, i.e. win market share during economic downturns.
- Intresting observation: Before corona and liquidity stress in the markets, investors’ perception of companies hoarding (too much) cash was rather negative. This perception changed a lot during the last few weeks as Cash is King once more.
Returning Cash to Shareholders
When discussing if SSBs are a form of creating shareholder value it makes sense to compare them against dividends (as another form of returning cash to shareholders). This is because other means of using excess cash result in keeping the cash within the company or reinvesting it into (other) businesses.
Dividends and share buy backs (SBBs) can be used returning cash to shareholders from the companys balance sheet. Both endeavors will leave the company with less cash on its balance sheet, since its transferred to its (former) shareholders.
Dividend payments are credited (net of tax) in the shareholders account, leaving shareholders with a higher cash position. The price per share declines (at the ex-dividend day) accordingly though, since nothing changed, besides the company has less cash in bank. The ex-dividend day, is the first day the shares are trading without claim to the next dividend. At this day, the price per share declines roughly by the dividend per share.
Share buy backs split the current shareholders into two groups. Some of them selling their shares to the company, ending up with a higher cash position. Others, hold on to their shares.
The sellers are credited with the current market price per share or PpS (net of tax) and are left with cash instead of shares. The PpS could get some support from such share buy backs, giving the sellers the opportunity to cash out at a (slightly) higher price.
Shares bought by the company become so called treasury shares, effectively lowering the number of shares outstanding. Usually the company cancels its treasury shares eventually. Canceled treasury shares are not eligible for reissuance.
Remaining shareholders own a higher relative share of the company and have a higher (relative) claim on the companies future earnings stream. On the same time, the company has less cash than before.
Do you prefer Dividends or Buybacks as a current Shareholder?
Obviously, you (and I) will answer this questions quite subjectively. In theory, shareholders preferring buybacks could use received dividends (net of taxes) to buy more shares in the market. And shareholders preferring dividends could sell their shares (partially) to generate cash (receive dividends). Neglecting transaction costs or fees, in this world share buy backs are preferable to dividends, based on the fact that dividend involve tax issues.
When the decision to return cash to shareholder is made, I prefer share buy backs, if I believe the company is currently undervalued (if it is fairly valued, or even overvalued, I should not own it).
- I prefer share buy backs, in which case i do not have to pay taxes on dividends.
- Additionally, I like the company to buy its own shares on a frequent (almost daily) basis in many small bites, taking advantage of depressed share prices.
The questions if companies should return cash to shareholders at all, is a question for another day. But let this serve as a primer:
Prof. Damodaran answering on How should companies decide when and how to deliver cash back to shareholders?
It’s one of the simplest of all corporate finance decisions, determined by whether you can earn a return for your investment that is greater than what people can make elsewhere, often referred to as a hurdle rate. For example, if people can make 8% elsewhere, you need to expect to make more than 8% from your reinvestment; if you cannot find investment that generates a return greater than that hurdle rate, then it is better to give the money back to your investors.Aswath Damodaran, interviewed by GS
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