Understanding stock buybacks

The increase in stock buybacks is an important trend. This post explores the basics of buybacks and some of the controversy they inspire.

Companies must choose how best to use their earnings. They can pursue new growth opportunities, they can pay dividends or they can purchase their own stock, a stock buyback (also referred to as a share repurchase). Corporations are spending a growing fraction of their earnings on buybacks over time. U.S. companies spent more than $1 Trillion on stock buybacks in 2018.

Aside from the implications for investors and the broader economy, buybacks have also become a hotly-debated political issue. Some politicians argue that companies, rather than buying back their own shares, should be increasing wages or engaging in productive activity that increases employment. Prior to 1982, buybacks were illegal because they were seen as a form of stock manipulation.

It is important to first understand the mechanics of buybacks. When a company spends cash to purchase its own shares, this increases the percentage of the company that each remaining share represents. Buybacks increase the value of each share that investors own. Buybacks are a mechanism to distribute a company’s earnings to current shareholders. In this way, buybacks are similar to dividends. In theory, shareholders should be largely indifferent as to whether a company spends earnings by increasing dividends, pursuing new growth, or buying its own shares. Buybacks increase the earnings-per-share (EPS) of a stock simply because there are fewer shares over which the earnings are implicitly distributed.

Because executives are increasingly compensated with stock options, they have a strong incentive to prefer stock buybacks rather than paying dividends or investing in new opportunities for the company. Dividends reduce the value of stock options and investments in innovation or growth take time. Buybacks, by contrast, have an immediate and predictable effect in increasing the value of stock options.

Why don’t companies use their earnings to increase wages, as opposed to engaging in buybacks (or increasing dividends)? The answer is simple. Management is contractually responsible to the shareholders and not to the employees. Unless increasing wages is considered to be in the best interests of the shareholders, management cannot spend the company’s earnings to increase employee compensation. There is, of course, considerable latitude for management to decide what is in shareholders’ best interest. Offering higher wages will allow a company to compete for better-educated and higher-skilled employees, which should be good for a company. If jobs require only low-skill workers, however, the most profitable route is to pay the least amount that will attract employees.

In general, investors will prefer for companies to pursue growth opportunities rather than engaging in buybacks. If management cannot find profitable avenues for growth, however, a buyback may be an attractive path. As an investor, I am generally indifferent as to whether buybacks are legal or not. The enormous increase in buybacks in recent years suggests that management is tending to use buybacks as an easy way to increase earnings per share (EPS) and their own compensation. I would rather see a company growing its total earnings by engaging in productive activities. More investment in new business opportunities should result in additional hiring and, ultimately, higher wages. This is not necessarily the case, though, not least because many new avenues for growth may be technology intensive and not require a lot of additional workers. That said, buybacks definitely won’t increase employment or wages.