Company stock repurchase. At times when the company feels the shares are undervalued, a share buyback is used to pump up the stock price, which acts like a support for the stock.

Company stock repurchase

Stock Buybacks or Dividends: What's Better?

Company stock repurchase. Rather, it's being spent to buy up gobs of company stock. In November , Goldman Sachs' chief equity strategist David Kostin estimated that, in , S&P companies will spend $ billion on buybacks — a new record. That's crazy. For most of the 20th century, stock buybacks were deemed illegal.

Company stock repurchase

Such a nefarious use of corporate funds makes for great headlines. But these claims are very rarely backed up by large-scale evidence, and often driven by a misunderstanding of how buybacks actually operate.

First, firms allocate funds to investment based on the opportunities that are available. Repurchases allow shareholders to reallocate funds to young, high-growth firms that are screaming out for a cash injection.

If paying excessive CEO salaries is the most maligned use of corporate funds, stock buybacks may well take second place. Conventional wisdom is that CEOs buy back stock to manipulate the short-term stock price. They fund the buyback by cutting investment, and so firm value suffers in the long-term. It boosts prices in the short run, but the real way to boost the value of a corporation is to invest in the future, and they are not doing that. The claim that the need to buy back stock forces firms to cut investment puts the cart before the horse.

A more plausible view goes like this: If they have spare cash left over after taking all value-creating investment opportunities then they may use it for buybacks. The evidence suggests this view is more accurate. Firms that buy back stock subsequently beat their peers by Rather than eroding long-term firm value, buybacks create value by ensuring that surplus capital is not wasted.

This highlights the value that can be unlocked simply by not frittering away corporate resources. In addition, buybacks 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 program this year, it can decide not to follow through with it with few negative consequences. Repurchases are much more flexible than dividends, the alternative way in which companies return cash to their investors, which attract less ire.

While a company can chop and change its repurchase policy depending on its investment requirements, it needs to maintain historic dividend levels since dividend cuts lead to a significant stock price fall.

This means that it is better to return surplus capital in the form of repurchases or through a special dividend because increasing the ordinary dividend implicitly commits the firm to maintaining the higher dividend level in the future.

The flexibility of repurchases is attractive for other reasons. Consumers with credit cards, and companies with revolving credit lines, value the option to pay back their debt at any time. They particularly overpay when the interest rate — the rate of return required by the bank — is high, just as firms particularly repurchase when the stock price is low and thus the rate of return required by shareholders is high.

If a credit card only allowed consumers to make the minimum payment every month, few would take out the card.

Similarly, if firms were restricted from buying back shares, they may not issue equity to begin with. Fewer companies would go public, instead financing themselves by taking on more debt. Debt is a useful analogy for a second reason. A borrower who pays back debt is making an investment that pays off in the future, by reducing her future interest obligations. Similarly, a company that buys back stock has to pay fewer dividends in the future.

And this represents a second advantage of buybacks over dividends. In a buyback, investors choose whether to sell their shares back. They will likely only do so if they have alternative investment opportunities; no rational investor would sell their stock and just horde the cash. Dividends are paid out to all investors, even those who have no good alternative investment opportunities and who may indeed allow the cash to sit idle. In this way, repurchases are targeted: Indeed, the fundamental premise implicit in many buyback critiques — that more investment is good and less investment is bad — violates a basic idea in Finance Investment only creates value if its returns are higher than the other projects shareholders could invest in.

It takes no skill to simply spend money. A restriction on repurchases could take us back to the s, where CEOs simply wasted free cash on building empires — RJR Nabisco being a prime example — rather than paying it out to be allocated elsewhere. Relatedly, few argue that equity issuance is a definitively value-creating action; indeed, selling shares significantly reduces the stock price if done without shareholder approval — as such issuances are most likely to be motivated by empire building.

Yet, repurchases are simply the opposite of equity issues. Yet another advantage of repurchases over dividends is that they lead to more concentrated ownership. If a company buys back stock, the CEO now has a greater share in the remaining equity, and so now has stronger incentives to improve firm value.

Higher CEO ownership stakes typically improve long-term stock returns. And buybacks concentrate the ownership of not only the CEO, but also of continuing shareholders. A common concern about the public corporation is that it is owned by millions of dispersed shareholders, whose stakes are too small to motivate them to look beyond short-term earnings.

By concentrating the ownership of continuing investors, they create blockholders — large shareholders. But, while the evidence suggests that buybacks in general add value, I am open to the idea that some buybacks indeed might be short-termist. A careful recent study shows that buybacks 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 buyback, but giving CEOs pay schemes that incentivize them to hit earnings targets. These contracts lead to investment cuts because such cuts help the CEO meet the target, regardless of whether the saved cash is used for repurchases or not.

Buybacks are a red herring. It is the investment cut that hits the earnings target that hurts long-run value. In addition to target-based contracts, the imminent vesting of CEO equity also leads to investment cuts. Thus, the solution is not to restrict buybacks — which would throw the baby out with the bathwater and constrain the many buybacks that do create value — but to remove earnings targets and require the CEO 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 buybacks that are value-destructive, but short-term behavior much more generally. Alex Edmans is a Professor of Finance at London Business School, where he specializes in corporate finance, behavioral finance, and corporate social responsibility.

Buybacks provide flexibility and push funding toward younger firms. Executive Summary Such a nefarious use of corporate funds makes for great headlines. Laura Schneider for HBR.


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