Corporations can buy back shares of the stock they previously issued. Buybacks – corporations can call them a share repurchase program – have the potential to serve both corporate and shareholder interests, though the practice has been controversial and the benefits aren’t always apparent.
Common stock repurchasing volume is enormous in the U.S. Repurchases by S&P 500 Index corporations exceeded $800 billion in 2019. That was about the same volume as the 2019 combined gross domestic products of Finland and Sweden. These two combined economies would rank in the top 13% of world economies.
Stock repurchasing volume increased in the early 1980s when the U.S. Securities & Exchange Commission significantly reduced regulations in Rule 10b-18. S&P 500 stock repurchases trended up, paused significantly during the Great Recession, then rose from a recent low of less than $200 billion in 2009. From 2010 through 2019, corporations spent $5.3 trillion to fund stock repurchases.
Walmart (WMT) is one of the leading corporate stock repurchasers:
- During the fiscal year (FY) ending in January 2021, WMT repurchased $2.6 billion of its shares.
- The net change (1) in shares outstanding (2) during FY 2021 decreased about 0.7% or about 19 million shares.
- Combined with its $6.1 billion in dividend payouts, the corporation returned to shareholders almost one-fourth of its entire fiscal year cash flow of $36.1 billion.
- Share repurchases in FY 2021 and the previous three fiscal years satisfied all but $3 billion of its 2017 plan to repurchase $20 billion worth of shares. In February 2021 the board of directors approved a new plan to replace the 2017 plan to repurchase $20 billion in shares, affirming its announcements to continue share repurchases.
Walmart’s share repurchase plan is not unusual. Here are two of the most aggressive repurchase plans in recent years:
- Apple (AAPL) is known for its accelerated stock repurchase plans. In just the last quarter of FY 2020 ending in September, the corporation repurchased 171.8 million shares for $56.4 billion. The net change in average shares outstanding during FY 2020 equaled -5.74%. For the three years starting near the end of October 2017 until October 16, 2020, AAPL’s net repurchases reduced average outstanding common stock shares by 17.21%.
- Qualcomm’s (QCOM) board of directors announced a plan in 2018 to repurchase $30 billion of its common stock. By December 27, 2020, the corporation had repurchased $25.8 billion worth of shares authorized in the 2018 plan. For the three years starting at the end of October 2017 until November 2, 2020, QCOM’s net repurchases reduced average outstanding common stock shares by 23.28%.
Stock repurchasing raises questions about whether it serves the fiduciary obligation of publicly held corporations. Do stock repurchases benefit shareholders and, if so, how do they benefit them? Is repurchasing stock a productive use of capital? Do companies with long-term debt effectively borrow to repurchase stock? Should corporations repurchase stock if they also received Paycheck Protection Program funds lent by the Small Business Administration during the COVID pandemic? We address these and related questions in the remaining paragraphs.
Why corporations do share repurchase programs
The goal of corporate financial management is to maximize the market value of owners’ equity. That’s another way of saying the goal is to maximize the market value of the stock. Even if the corporation hasn’t issued traded stock, maximizing owners’ equity value still works because all corporations issue stock (traded or not); total outstanding stock value is equal to owners’ equity. All financial objectives, decisions, and actions should serve the goal to maximize the market value of owners’ equity.
This goal might come as a surprise to some people. It sounds self-serving, exclusive, and omits any consideration for the customer and other important values like the environment and corporate citizenship. After all, isn’t Walmart’s goal to make the customer number one? That is the corporation’s stated mission. Most corporations express their mission in customer benefit terms.
But customer benefits do not explain how corporations spend money. It’s all about shareholders. Ideally, benefits to shareholders trickle through to customers and other stakeholders.
Somehow, then, corporate financial managers engaged in repurchases must believe their actions serve the owners’ equity goal. The short explanation is that repurchasing stock 1) reduces the supply of outstanding shares and 2) returns cash to shareholders who sell the stock to the corporation.
Yet, repurchasing is not the only way to maximize the value of owners’ equity. To responsibly address whether repurchasing is good for investors, it’s worth looking at the alternative methods used to achieve the financial management goal. After all, a decision to repurchase stock means management decides not to invest the cash used in the repurchase to invest in projects, pay dividends, or do other things that might maximize the market value of owners’ equity.
How corporations maximize the market value of owners’ equity
Corporations with more cash than they need to fund day-to-day operations can either bank the cash or return it to shareholders. Banking cash usually fails to yield a suitable return on investment. Some shareholders would consider it a failure of the corporation’s fiduciary obligation to bank too much cash. One of the most widely reported lawsuits concerning a corporation’s alleged excess cash balance came in 2013 when a shareholder sued Apple to distribute more of its $137 billion cash balance to shareholders. The alternative to hoarding cash – returning cash to shareholders – can be a direct payment or investments that grow the equity balance. Besides repurchasing stock, corporations use three strategies to maximize the market value of owners’ equity:
- Capital budgeting is the process of making long-term corporate investments. The size, timing, and risk of expected cash flows created by the investments provide decision-making criteria on the suitability of potential investments. Usually, capital budgeting concerns business project decisions like whether to open a retail store in a certain location or to manufacture a new product like battery-powered lawnmowers. But any investment can produce cash flows. Stock and bond investments produce cash flows, and many businesses use the securities of other issuers to earn dividend, interest, and capital gain cash flows. However, when corporations repurchase stock, the shares cease to pay dividends. Usually, the corporation intends to permanently retire the shares, so they would not be reissued to produce dividend cash flows for shareholders. Capital budgeting decisions can serve the financial management goal because when investment returns exceed expense, they can increase net income which, in turn, can lead to increases in stock market value.
- Dividend policy concerns the size and timing of cash payments to shareholders. Many investors prefer dividend-paying stocks. Dividend payments contribute to the goal because they are one of the factors that can increase stock prices. It isn’t just cash dividend payments to shareholders that contribute to the goal. The dividends might increase the owners’ net worth, but that’s not the goal. Rather, the benefit to the market value of owners’ equity lies in 1) the support dividends give to stock market values and 2) the upward influence on stock prices when shareholders reinvest dividends in the associated stock.
- Acquisitions of other businesses give the acquiring business the opportunity to increase total revenue which can lead to an increase in net income. Rising net income can increase the value of its stock, thereby satisfying the goal.
A corporation has limited resources and multiple competing objectives. Therefore, financial managers seek an optimum allocation to investments, dividend payments, acquisitions, and share repurchases. The corporation’s cost of capital is the most important optimization guide. Risk, investment returns, and the cost of capital underlie optimization. Here’s the thinking that underlies optimization:
- Capital is the source of funding for the corporation.
- Investors contribute capital to the corporation, an act that forces them to assume risk.
- Part of the corporation’s fiduciary obligation to its investors lies in investing capital to compensate investors for the risk they assume.
- The corporation assumes expense to use investors’ capital. The simplest example is interest paid on debt. If a corporation’s average interest rate for all debt equals, say, 5%, then its cost for debt capital equals 5%. If this debt is the corporation’s only capital funding, then 5% is the corporation’s cost of capital. The corporation’s cost of capital is the breakeven investment return rate.
- To compensate investors for the risk they assume, the corporation’s investment returns must exceed the cost of capital and be sufficient to compensate investors’ risk.
Financial managers optimize capital allocation by using this four-component portfolio of strategies – capital budgeting, dividend policy, acquisition, and repurchases. The repurchase strategy can help maximize the market value of owners’ equity in a way that’s similar to the influence of dividend payments because it’s a direct cash payment that indirectly affects the stock price.
How share repurchases can help maximize the market value of owners’ equity
It all starts with the balance sheet. Repurchase transactions have no bearing on expense or net income. They’re strictly balance sheet transactions. The cash payment for shares reduces (credits) the cash account balance and also reduces (debits) the treasury stock account – this is an account – a contra-account – in the equity portion of the balance sheet. Subsequent changes in the market value of outstanding shares have no bearing on the treasury stock account balance, nor does the corporation pay dividends on treasury stock. The treasury stock debit reduces the total equity balance.
Because the accounting transaction reduces the equity balance, the book value of the corporation declines. That might sound like repurchases reduce the value of equity, which would be exactly the opposite of the corporate financial management goal. However, the goal concerns the market value of equity, not its book value. Usually, the decline in the supply of shares has greater influence than the decline in the book value on the market value of owners’ equity.
This balance-sheet-only property of repurchases is critical to the value they can add to the market value of owners’ equity:
- Net income is one of the most influential accounting values investors use to value stock. If share repurchases were treated as an expense on the income statement, then net income would decline if everything else were held constant. The transaction would tend to suppress short-term stock value and the market value of owners’ equity because of the net income decline.
- Earnings – “net income” is the equivalent term – per share (EPS) is one of the most influential accounting ratios investors use to value stock. The EPS ratio is total earnings in the numerator divided by total shares in the denominator. The repurchase reduces the denominator, so the value of EPS increases. Also, EPS is the denominator in the venerable price-to-earnings (P/E) ratio. An increase in EPS reduces the P/E ratio value making the stock appear less expensive and, thus, more attractive for investors looking for a bargain.
- Other ratios benefit from repurchase. For example, the credit to cash and the corresponding debit to equity reduce total assets and total equity. These are the denominators in the useful return-on-assets (ROA) and return-on-equity (ROE) ratios. Repurchases increase these ratio values suggesting the corporation has more productive assets and equity.
- These ratio effects can be confusing for investors – some would even say they’re deceptive because they only reflect financing transactions and not the results of more effective business practices. For example, if an investor observes an increase in the ROA of a corporation they might want to invest in, is the increase because management improved its productivity with respect to assets or is it because management reduced the asset account balance to repurchase shares? The repurchase practice diminishes the information value of some accounting ratios and it forces prospective investors to gather more information for decision-making.
Repurchases can also help maximize the market value of owners’ equity by directly returning cash to shareholders. Corporations execute repurchases in three ways to return cash to shareholders:
- Open market transactions – The corporation enters buy orders the way any other investor would in the secondary market.
- Tender offer – The corporation announces to shareholders its commitment to buy a certain number of shares at a certain price during a certain period.
- Targeted repurchase – These transactions occur between the corporation and a certain shareholder. This tactic can deflect an uninvited takeover from a different corporation. For example, Corporation A holds 15% of shares issued by Corporation B and announces plans to accumulate over 50% of outstanding shares to gain control of Corporation B; Corporation A purchased the shares for $20 one month ago. To undercut Corporation A’s takeover attempt, Corporation B offers to buy all of Corporation A’s shares for $30. The profit to Corporation A deflates its attempt to take over Corporation B.
Both repurchases and dividends return cash to shareholders. But the taxing authorities benefit less from repurchases than from dividends.[iii] Dividends get paid from after-tax net income. Then shareholders pay tax on their dividend income. That’s double taxation. However, the money used to fund repurchases is net income on which the corporation paid tax sometime in the past. The tax was paid once. The only additional taxes paid in relation to repurchases is tax shareholders pay on capital gains earned when they sell stock back to the issuer.
The other relative advantage of repurchases lies in the benign effect on stock prices when corporations decide to postpone or reduce the size of repurchases. But when they postpone or reduce the size of dividends, stock prices usually tumble.
Other issues to consider in evaluating whether share repurchases are good for investors
A few other factors are worth considering about share repurchases:
- Many popular media journalists make a case that share repurchases are bad practices, and some have even called for government regulations to stop or severely restrict them. Most arguments contain legitimate concerns, but they can also reflect a premise foreign to the purpose and contributions corporations make to economies, the culture, and society:
- The goal to maximize shareholder wealth and its corollary to compensate shareholders for the risk they assume are flawed. Sometimes this argument rests on a preference for regulations that would result in higher wages for employees or investments that can serve the greater good. This argument is often associated with concerns about wealth inequality.
- Repurchasing can serve the selfish interests of insiders and contribute to stock price manipulation.
- Corporate management decisions to repurchase shares are short-sighted and ignore other investment opportunities that could serve the long-term growth of the corporation and more effectively support the communities in which the businesses operate.
- Regulatory authorities, particularly in the European Union, offer models for more effective control and reporting of repurchasing.
- Research on the relationship between repurchases and stock prices generally confirms a positive relationship. In a classic 1981 study, the author concluded share repurchases, like dividends, provide a favorable “information signal” about the corporation’s financial condition. More recent research confirms earlier findings but reveals detrimental effects including lower growth and innovation.
- If a corporation assumes debt and repurchases stock even though the borrowed cash wasn’t directly used in the repurchase, a case can be made for a misappropriation of capital. A potentially more egregious practice lies in borrowing to specifically fund repurchases. Debt increases corporate risk, but repurchases fail to produce net income capable of mitigating the additional risk.
- Some corporations also repurchase shares when its managers think they are buying the stock at a low price. For example, Berkshire Hathaway’s (BRK-A, BRK-B) share repurchase plan authorizes Warren Buffett (Chairman of the Board and CEO) and Charlie Munger (Vice Chairman of the Board) to repurchase shares of either share class whenever they believe market prices are less than the corporation’s intrinsic value. During just the last quarter of FY 2020 ending in December, the corporation spent $8.78 billion to retire common shares. This practice can serve the owners’ equity goal if the corporation subsequently reissues the shares and earns a profit on the sale the way any corporate profit can serve the goal. However, buying from shareholders when the price is low also seems to compete with shareholder interests; the corporation might benefit, but if the return of cash to the selling shareholders results in capital losses for them, the transaction diminishes the market value of owners’ equity.
- Questions arose around the “Paycheck Protection Program” (PPP) the Small Business Administration executed to help corporations fund employee compensation and certain fixed costs during the pandemic. The program did not prohibit corporate recipients from returning to shareholders cash from other sources – thus, dividends and repurchases were not prohibited. But some people and organizations thought wealthy corporations might have abused the program or that the program regulations were so loosely constructed the benefits went to the “well-resourced and well-connected” rather than those they thought were the rightful beneficiaries.
- Corporations consider repurchases when the other opportunities to return cash to shareholders – capital budgeting, dividends, and acquisitions – are limited or fail to satisfy the cost of capital standard and the objective to compensate shareholders for the risk they assume.
The most important criterion for judging whether share repurchases are good for investors lies in their effect on the market value of owners’ equity, which is the overriding standard for all corporate financial decisions. The reduction in outstanding shares provides the most reliable factor contributing to the market value of owners’ equity. However, the confluence of variables influencing market values and the uncertain consequences of corporate financial transactions render uncertainty about repurchase benefits. In general, repurchases are good for investors, but the details of the transactions and their often unforeseeable consequences govern their value.
1 Like many corporations, Walmart’s employee compensation includes shares of stock. The net change includes shares issued to employees, which offset repurchases.
2 “Outstanding” shares are authorized and issued shares of stock held by the investing public. “Authorized” shares are the shares legally approved; they include outstanding shares eligible for future sale. A third category is “treasury” shares. They are the shares the corporation previously issued – they had been outstanding – and subsequently repurchased.
3 Opposition to stock repurchases usually includes legitimate concerns that should be weighed with other factors. “Follow the money” advice can be useful for understanding the motivation of the opposition.