January 28, 2021
This is a Twitter thread from a couple of months back. I thought I would post it here since there may be some interest.
Someone sent me a diatribe from some progressive about the evil of share buybacks. I have a few thoughts.
First the claims: they allow companies to inflate share prices, top management to manipulate share prices to maximize the value of options, divert money from long-term investment, and allow for tax avoidance. I’ll start with the tax story.
Buybacks, as opposed to dividends, do allow shareholders to avoid paying taxes as long as they hold their stock. This is a gift to rich people, but let’s not get carried away on the size of the gift.
First, as many progressives (including me) complain, shares typically turn over very quickly. That is one reason many of us support a financial transactions tax – to reduce the volume of pointless trading.
You don’t get to both complain about shares turning over all the time and that rich people never pay taxes because they hold their shares forever.
It’s true that some rich people do hold their shares until death, but even the Waltons must occasionally sell some shares to cover their living expenses. Anyhow, this is a real issue (could be addressed by taxing unrealized capital gains), but let’s not exaggerate its size.
On the question of long-term investment, I’m not at all impressed with the evidence. Do we think that companies would invest more if they paid out money to shareholders as dividends?
If the point is that the more money companies pay out to shareholders (as either dividends or buybacks), the less they invest, sure that is almost definitionally true. But this begs the question.
Are they paying out money to shareholders because they don’t see good investment opportunities or whether they aren’t taking advantage of good investment opportunities because they are paying out so much money to shareholders? I am strongly inclined to believe the former is the case.
Now let’s ask about inflating the share price. Suppose a stock sells for $100 and it is expected to earn $5 a share until the end of time. What happens if the company uses its full $5 in earnings to buy back stock.
The buyback critics tell us this would drive up the share price. In a limited sense, this will almost certainly be true. Suppose that we now have 5 percent fewer shares outstanding. This means that if we have the same price-to-earnings ratio, then the price per share will be 5 percent higher.
But how is this “inflating” the share price? The price to earnings ratio would be exactly the same after the buyback as before. What’s the problem?
We can tell a story that buybacks actually increase the price-to-earnings ratio. PEs have been unusually high in the last two decades, so this is not an implausible story on its face, even though believers in efficient market theory would say it’s impossible.
If buybacks do in fact drive up PEs, it would benefit top management, who will get more money for their options, and disadvantage future shareholders who will have to pay more money for each dollar of earnings, meaning that they will lower returns on the stock buy.
Current shareholders will be largely indifferent to a rise in PE since they have little reason (apart from tax considerations) to prefer money paid to them in higher share prices as opposed to dividends.
In this story, buybacks are effectively a tool used by top management to gain at the expense of future shareholders, with current shareholders being indifferent.
This raises the last point, top management using buybacks to manipulate stock prices to maximize the value of their options. This strikes me as a very plausible story, but it has important implications.
If top management is manipulating stock prices to increase the value of their options, it implies they are ripping off their companies. After all, if the shareholders wanted the CEO and other top executives to get more money, they could have just paid them more money.
The manipulation story implies that they are taking money that the shareholders, or their agent, the board of directors, did not intend them to have.
The manipulation story also means that the claim that the company is being run to maximize returns to shareholders is not true. In this case, the shareholders should be allies in efforts to rein in CEO pay.
To my view, reining in CEO pay is very important because of the distorting effect it has on pay structures throughout the economy. A world where CEOs get paid $2M (like in the good old days) is very different than today’s world where they get paid $20 M.
This leaves the moral of the evil buyback story as being that we need to crack down on CEOs ripping off their companies and bring their pay down to earth.