If paying excessive chief executive salaries is the most maligned use of corporate funds, stock buy-backs may well take second place.
Conventional wisdom is that chief executives buy back stock to manipulate the short-term stock price. They fund the buy-back by cutting investment, and so firm value suffers in the long-term.
But these claims are very rarely backed up by large-scale evidence, and are often driven by a misunderstanding of how buy-backs actually operate.
The claim that the need to buy back stock forces firms to cut investment puts the cart before the horse. A comprehensive survey of financial executives concluded that “repurchases are made out of the residual cash flow after investment spending”.
Other studies find that chief executives repurchase more stock when growth opportunities are poor and when they have excess capital. It is the exhaustion of a firm’s investment opportunities that lead to buy-backs, rather than buy-backs causing investment cuts.
Moreover, the claim that buy-backs weaken companies in the long term isn’t borne out by the data. Firms that buy back stock subsequently beat their peers by 12.1 per cent over the next four years.
In addition, buy-backs offer firms the flexibility to vary how much they return to shareholders year to year. Even if a company repurchased lots of stock last year, it can buy back zero this year. Even after announcing a repurchase programme this year, it can decide not to follow through with it with few negative consequences.
The idea that buy-backs stifle investment considers investment only in the company in question and ignores the fact that shareholders can reinvest the cash returned elsewhere.
And this represents a second advantage of buy-backs: in a buy-back, investors choose whether to sell their shares back. They will probably only do so if they have alternative investment opportunities. In this way repurchases are targeted: They return cash to shareholders with the best other uses for it, allowing them to reallocate funds to young, high-growth firms screaming out for a cash injection.
Stronger incentives
Another advantage of repurchases is that they lead to more concentrated ownership. If a company buys back stock, the chief executive now has a greater share in the remaining equity and so has stronger incentives to improve firm value. Higher chief executive ownership stakes typically improve long-term stock returns.
While the evidence suggests that buy-backs in general add value, some buy-backs might indeed be short-termist.
A recent study shows that buy-backs that allow a company to just beat analyst earnings forecasts, when it would have missed it otherwise, are associated with future reductions in employment and investment. But the problem here is not so much the buy-back, but giving chief executives pay schemes that incentivise them to hit earnings targets. These contracts lead to investment cuts because such cuts help the chief executive meet the target.
Buy-backs are a red herring. The solution is not to restrict buy-backs but to remove earnings targets and require the chief executive to hold stock for several years. This would solve the myopic incentives that are the root cause of any problem, deterring not only the few buy-backs that are value-destructive, but short-term behaviour much more generally.
– Copyright Harvard Business Review 2017
Alex Edmans is a professor of finance at London Business School
