As the stock market raced ahead of the real economy in recent years, the increasing volume of buybacks was criticized by those that felt that firms were channelling funds away from productive investment into seemingly wasteful financial engineering. Now that they have passed a peak, the decrease in buybacks is being interpreted as a signal that management believes its stock is overpriced, and therefore not worth buying. Buybacks are not deserving of this double-edged rebuke, nor the confusion that surrounds what they represent.
Buybacks are first and foremost a capital structure decision and they are much more similar to dividends than is often suggested. Furthermore, the supposed trade-off between investing to grow and investing in one’s own stock confuses the sequence of decisions in the capital allocation process and needlessly adds complication.
Buybacks and dividends both take cash from the company and give it to shareholders. Dividends treat all shareholders equally; buybacks on the other hand change the composition of the shareholder base and in doing so increase leverage only for continuing shareholders. Buybacks are better than dividends for continuing shareholders if the market value of the firm subsequently increases, which is more likely to happen if the market value is below intrinsic value. But buying back stock when the market value is below intrinsic value, though often lauded, is not necessarily a good capital allocation decision. The firm may have capital investments that would have created even more value for shareholders.
A good capital allocation process looks first at opportunities to invest in projects that are sufficiently likely to earn a return in excess of the firm’s cost of capital. The correct cost of capital to use is market implied, not the theoretical (and, almost always, wrong) one that comes from a spreadsheet in Canary Wharf or Wall Street.
Next, the process turns to how these capital investments should be funded. If funded entirely from profits (ie equity), then leverage will fall. This is good only if leverage was too high to start with. If funded with a mix of debt and retained profits, firm leverage can be held constant or adjusted to a closer-to-optimal level. Only if there is excess cash flow following this, should the firm look to return these to shareholders.
It can use dividends or buybacks to do so. Dividends are more likely to be used if there is a long term decision to return a percentage of profits. Buybacks are seen as more flexible. This is convention and need not be the case. Of course, shareholders can decide to create a synthetic dividend during a buyback or use proceeds from a dividend to buy additional stock.
Separately, the idea that buybacks signal a cheap stock is flawed. If a company’s stock is trading at a relatively low multiple, it may be that the market’s estimate of the cost of equity is high, rightly or wrongly. Or it could be that growth prospects are low. Mixing these up and using the outcome to justify buybacks is bad for shareholder value creation. A high multiple may be a sign of growth opportunities with high returns so you are less likely to see a lot of cash left over for buybacks/dividends. But the stock may still be cheap.
As stock prices go up the hurdle rate for internal projects comes down and firms channel more into investment projects, leaving less to return to shareholders. If the hurdle rate subsequently goes up (ie share prices fall) it doesn’t make the previous decision to invest a bad one, but may mean it is harder to justify investing additional cash into the same project. All projects should be NPV positive at the time of funding, decisions to increase or decrease the size of the project at a late date should similarly be NPV positive.
So, capital returns to shareholders should naturally be low when valuations are high and vice versa. The reduction in capital return that has been noted after the rise in share prices is what one should expect, all else equal. The fact that a peak in buybacks didn’t happen earlier as the market advanced, probably reflects executives being too conservative in estimating IRRs on projects and being paid for non-productive activities such as reducing the number of shares outstanding.
Buybacks are not an investment in one’s own shares; they are a means, just like dividends, of reducing the amount of shareholder equity and hence changing the capital structure of a company. Constructive discussions about the role of buybacks should take this as a starting point and, with some hope, buybacks will shake off their unjustified reputation as a dark force in the capital markets.