In a recent New York Times op-ed, Democratic senators Chuck Schumer of New York and Bernie Sanders of Vermont made a case against stock buybacks, arguing that they do not benefit the vast majority of Americans and restrain a company’s ability to reinvest profits in research and development, equipment, higher wages, paid medical leave, retirement benefits, and worker retraining.
The senators intend to introduce legislation prohibiting buybacks unless a company “invests in workers and communities first,” including, for example, paying workers at least $15 per hour, providing seven days of paid sick leave, offering “decent pensions” and “more reliable health benefits.” Acknowledging that companies might switch to dividends to avoid the buyback restrictions, the senators said they might limit dividend payouts “perhaps through the tax code.”
Sen. Marco Rubio of Florida has also stated that buybacks should be constrained. Rather than impose preconditions on buybacks, Rubio intends to introduce legislation that will tax the dollar amount of buybacks as if they were dividends. By imposing this tax, Rubio expects companies will avoid buybacks and instead make greater capital investments in their businesses, resulting in more efficient operations, better products and higher worker pay.
Both of these proposals suggest a lack of appreciation for the role that buybacks play.
Misconceptions Related to Buybacks
First, it is a misconception to think that the dollar amount of a buyback translates into an immediate increase in the value of a company’s shares of an equivalent amount, thereby enriching shareholders. Since the value of outstanding shares retired by the buyback will equal the amount of cash taken off the balance sheet to effect the buyback, the book value of each share of stock after a buyback will be the same as it was before the buyback. As a result, insofar as book value is concerned, the holders of the non-retired shares receive no immediate benefit from the buyback.
Due to market forces and the fact that market prices reflect factors other than book value, it cannot be said that the market price of a share of stock after the buyout is identical to the market price before the buyout. It can, however, be said that the total market value of the company is unlikely to increase immediately by an amount anywhere near the dollar amount of the buyback.
Over time, buybacks and their concomitant decrease in outstanding shares will enhance share value. Earnings per share increase. Consequently, irrespective of whether price earnings ratios and the company’s earnings remain constant or go up or down, the price of the shares will be higher than what the price would have been had there been no buyback. Of course, whether the share price in fact increases will depend upon whether the company’s post-buyback earnings do not decrease and whether general or industry-specific conditions do not lower price earnings ratios.
In addition to higher earnings per share, each share will have a greater claim to the pool of cash that the company uses to pay dividends and to the liquidation value of the company’s assets. These claims should have a positive price effect.
Second, buybacks are an essential tool allowing companies to award stock options and share grants to employees. Because of the dilutive effect resulting from employee equity awards, companies would be disinclined to make such awards if they could not use buybacks to reduce or eliminate the increase in outstanding shares resulting from the awards. Since it is generally understood that employee equity ownership boosts a company’s performance, buyback constraints are likely to prove deleterious.
Third, although buybacks benefit the executive suite and wealthy investors, they also benefit rank-and-file employees in several ways. For example, employees who participate in 401(k) plans with an employer stock fund can benefit. In addition, employees can benefit if their employers maintain employee stock purchase plans or broad-based stock option plans. The National Center for Employee Ownership estimated in 2015 that approximately 32 million Americans own employer stock through these and similar programs. More generally, equity-based mutual funds benefit from increased share prices, so participants in 401(k) plans who invest in mutual funds can also benefit.
Fourth, no board of directors is likely to authorize a buyback, even to combat the dilutive effect of employee equity awards, if management and the board conclude that monies are needed to improve or expand the business or to develop new businesses for which the company is well suited. It is fair to assume, therefore, that buybacks are not made at the expense of a company’s business but only when a board determines that the company has no productive use of additional monies.
Fifth, contrary to what Schumer and Sanders suggest, there is no correlation between buybacks and layoffs. There simply is no evidence that layoffs are used to fund buybacks or that a cessation of buybacks will result in fewer layoffs.
Buybacks Aren’t Really Controversial
Buybacks have been around for a long time. Although execution has sometimes been criticized, especially when companies have bought back shares at inflated prices or borrowed to fund the program, they have not been controversial. The 2017 reduction in corporate tax rates, however, has resulted in a significant increase in the dollar amount of the buybacks. As Schumer and Sanders note, in 2018, companies announced more than $1 trillion worth of buybacks.
This amount is misleading since only 19 companies account for almost half of it, suggesting that there is not a buyback pandemic. Nevertheless, numbers of this magnitude have prompted the calls for reform.
Schumer and Sanders argue that companies have many constituencies, of which shareholders are only one. Others include employees, communities in which a company operates, and society at large. These other constituencies should share in corporate profits, if not on a par with shareholders, at least in some reasonable proportion to them.
Even if one accepts the premise of multiple constituencies, the basic question is whether government or a company’s management and board of directors are best suited to determine each constituency’s share of profits. Since each company’s situation is unique, the one-size-fits-all strictures of governmental regulation seem inappropriate. Moreover, the rise of ESG (Environmental, Social and Governance) investing, which favors companies that properly compensate and otherwise treat their employees and that minimize the negative impact of their operations on the environment, will in time motivate companies to recognize all constituencies and obviate the need for governmental intervention.
Why Would Regulation Help?
If it is appropriate to impose preconditions on buybacks, as proposed by Schumer and Sanders, it is preferable to require companies to increase 401(k) plan coverage and contributions rather than to increase current pay or liberalize non-retirement benefits. Many millennials do not adequately save for retirement because of student loans.
Moreover, PNC Financial Services did a recent survey of the “sandwich generation” (those ages 36 to 60, who often support both children and aging parents) and found that 32 percent have less than $25,000 saved for retirement and more than 50 percent have less than $100,000. The country will be better off if employees have greater retirement security than if they have a somewhat higher paycheck.
Rubio has a different take. As Congress communicated, the principal justification for reducing the corporate tax rate was to make U.S. companies more competitive with their international peers and to provide them the economic wherewithal to improve and expand their businesses. Rubio’s tax proposal is intended to accomplish this goal by encouraging companies to reinvest profits in plant, equipment, and other means of growing their businesses.
Equating buybacks with dividends is illogical. Rather than discourage buybacks, the proposal is likely to stop them altogether. Moreover, the proposal may not achieve its goal since companies that wish to return monies to shareholders will simply do so in the form of dividends.
Ultimately the board of directors and management are best prepared to decide how a company’s profits are most effectively used and to analyze issues such as whether employees are being appropriately remunerated and what the company’s capital needs are. Imposing restrictions or taxes on buybacks in an effort to supplant their role is a dangerous game that borders on the type of governmental intervention befitting a state-controlled economy, not a market-controlled economy.