Author: Value Investor
Date of publication: 2020-04-22
There is a lot of hype about US companies spending obscene amounts of money on purchases of their own shares. But is it really that good for shareholders as we are led to believe?
There was a discussion today at CNBC about companies purchasing their own shares - so-called stock buybacks. Investors generally are ardent supporters of that: it is akin to capital distribution to shareholders but without tax implications for the latter, unlike dividends on which taxes have to be paid. From what Josh Brown, the CEO of Ritholtz Wealth Management, has said during that discussion, in the last quarter of 2019 alone US companies have spent around $200 billion for purchasing their own stock. He went on to say that even though, unlike dividends, this is not a direct distribution of money, it is a much better deal for shareholders nonetheless - because of the tax thing. With share buybacks, there are less shares outstanding and each share should cost proportionally more for the same company valuation. You don’t receive the money minus tax into your bank account, but your investment account should increase in value by full amount of the share buyback (no taxes are levied on this). It seems like a great thing. Right? Well, not necessarily. I greatly respect Josh Brown and like his commentaries on the market and specific stocks, but he did not say a very important thing in regard to stock buybacks. In the vast majorities of cases these buybacks are made to offset share dilution caused by so-called share-based compensation. This is when in addition to salaries, company employees also receive stock options or other similar packages. In theory it is supposed to motivate employees to work better and harder so that the company stock price will rise and they will benefit from it. In reality, though, the primary purpose of this stock-based compensation is to increase payouts to top managers without raising their regular salaries to obscene levels. So, how does it work? In a very simple way it works as follows. Let’s say a company grants to its CEO stock options to purchase say 100,000 shares at the current price of $100 but after at least three-years have passed from the stock option grant. If in three years the share price is still the same $100 or less, these options held by the CEO are worthless - but he can still hold on to them for a few more years and cash them at any time when the share price goes above $100. Or the company, at its own largess, could rebase the stock options - lower the price at which they were granted (and many companies do just that). If, on the other hand, the share price is above $100 after the three-year period, the CEO could exercise the options or continue to hold on the them in an expectation of further gains. For illustrative purposes, let’s just assume that the stock price after three years is $150 and the CEO decides to exercise the options. That would entail the company selling him treasury shares (those that are held by the company itself) at the grant price of $100 per share and him selling those shares at the market price of $150. So, the CEO pockets $50 per share on this deal. But where is this money coming from? Ultimately from the company’s bank account. Because in order avoid the share dilution the company buys the same amount of shares back (at the market price of $150). If there were not share buybacks, with the scale of share-based compensation in the vast majority of companies, there would be a massive share dilution and all those stock compensation grants would be under water. But wait, how does an ordinary shareholder benefits from this? Theoretically, from better operations of the company run by more motivated managers. But I am very skeptical of this premise. I am always amused how the share price rise when a company announces a massive share buyback program. I guess, it should be better than if there is a massive share-based compensation and no buybacks. But at the end, from the economic impact for an ordinary shareholder, it is the same thing, and I would be more tempted to sell shares after such announcements.