Buybacks are a Capital Structure Decision not an Investment Decision

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.

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10 thoughts on “Buybacks are a Capital Structure Decision not an Investment Decision

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  2. Great post. You explain your points in a simple and concise manner. I agree with your propositions and conclusions, but was hoping you could clarify one thing…

    I understand why repurchasing shares at a “high” market valuation (read: one that exceeds intrinsic value) should be avoided as it benefits selling shareholders at the expense of remaining shareholders, for whom it destroys value. However, I’m less clear when it comes to why capital returns to shareholders in the form of dividends (as opposed to share repurchases) should be low when market valuations are high. If you can help me wrap my head around this I’d appreciate it.

    And again, great post.

    Reply
  3. Thanks for the comment. A higher share price lowers the hurdle rate for re-investment (ie lower cost of equity), so, all else equal, capital return should be lower since more of the profit accruing to shareholders will be retained in the firm. It doesn’t matter whether the capital return takes the form of buybacks or dividends in this instance. Hope this helps.

    Reply
  4. Isn’t “capital structure decision” vs “investment decision” a false dichotomy?

    Don’t corporations mainly focus on EPS accretion? A buyback is just another way of boosting EPS, as an alternative to capex.

    Reply
    • You raise an interesting point. Corporations should focus on maximising the net present value (NPV) of future cash flows. That is often, though not always, consistent with maximising EPS. Maximising EPS over an infinite time horizon should get you to the same result, but doing so over a short time horizon (eg one quarter) very often does not. This highlights a major issue with capital markets and the incentive structures that are in place today. Secondly, it is important to think about investment decisions and capital structure decisions not as alternatives but as sequential nodes in a decision tree – both need to be done optimally in order to maximise the NPV of future cash flows.

      Reply
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  8. The approximation of stock repurchases to dividends seems to be a popular understanding but it is one which oversimplifies the issue. Stock repurchases are like dividends, all of which are re-invested in the company’s stock. In reality very little of a company dividend will be reinvested in the stock of the same company. Thus, stock repurchases are like dividends that create new demand for a company’s stock, driving its price higher. the difference between the two fundamentally alters the stock’s supply/demand relationship. Thus the two are quite far from analogues of each other.

    In a real-world sense this becomes important when we observe the incidence of stock repurchases and their steady rise up to points of major market decline. Contrary to some theories of corporate financial structure in toto companies do not exploit asymmetric informational advantages to repurchase stock cheaply (or sell it at a high price). They follow the market up in their repurchasing activity and are forced to issue new equity at low prices after the market crashes.

    Reply
    • Shareholders who sell when the company is buying are, on a net basis, also not going to reinvest in the stock of the same company so, on that point, buybacks and dividends do not differ. The fact that fewer shares exist following a buyback is important to think about with regards to your first point.

      On your second point, there certainly have been points in history when companies have increased leverage prior to a decrease in the enterprise value of the firm and there will be more instances of that in the future. The key is whether a management team is managing its capital structure effectively relative to the risks the business faces – not an easy task by any stretch. Thanks for your comments.

      Reply

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