London Business School finance professor Alex Edmans devotes a substantial portion of his excellent book Grow the Pie to stock buybacks. His discussion offers an honest recapitulation of both the political and financial case against them, showing that he has taken that point of view seriously. He then describes what buybacks actually are and what they do, in order to get people oriented around an accurate understanding of the fact pattern. Then he offers a partial defense of stock buybacks, with some suggestions for dealing with the particular situations in which buybacks shrink, rather than grow, the pie.
I'll familiarize the reader with his arguments and interact with them in several stages.
The standard horror story about stock buybacks is the story of Humana in 2014. The CEO of Humana had a compensation package which strongly incentivized him to hit a certain earnings per share (EPS) number. If he could hit $7.50 per share, he got his bonus.
The CEO initially engaged in a standard earnings shenanigans move: classifying an expense which is reasonably likely to continue to occur as a non-recurring item. By doing that, the expense is not used to calculate the earnings portion of EPS. But even after that, he was still short a few pennies, so he launched a large stock-buyback program. The math is simple. EPS is earnings divided by the outstanding shares. If you decrease the number of shares outstanding, you shrink the denominator without changing the numerator (since buybacks are not treated as an expense), raising the ratio. He hit his target, got his bonus, (despite Humana having been an underperformer) and added credence to the idea that share buybacks are basically just a way to game the system.
Edmans acknowledges the problem:
"But buybacks allow the leader to meet an EPS target artificially without actually raising firm performance, because they lower the number of shares outstanding…"
As a result of anecdotes like this and a serious dearth of financial literacy among politicians, buybacks became a political whipping boy.
"…politicians – surprisingly, from both sides of the political spectrum – are calling for restrictions on buybacks. In February 2019, Democratic Senators Chuck Schumer and Bernie Sanders published a plan to limit share repurchases, and a week later Republican Senator Marco Rubio announced his own proposal."
Edmans differs from this bipartisan consensus, going on to argue,
"[…] that pie-growing enterprises should engage in far fewer buybacks than those that practise ESV. But I’ll also stress that, properly executed, buybacks can grow the pie. Of course, the critical words are ‘properly executed’ and ‘can’. So we’ll use large-scale evidence to show that, in most – but not all – cases, buybacks do create value."
One of the root problems with anti-buyback fervor is a simple lack of understanding about what buybacks are. Critics treat them as some sort of ‘gimme’, an undeserved gift, a windfall for investors.
"But buybacks aren’t a freebie where investors get something for nothing. Investors do get cash, but only in return for giving up their shares."
-- Alex Edmans, Grow the Pie
When investors buy shares, they give up cash to gain future claims on the companies they invest in. They buy something. Well, when companies buy those shares back, they are spending money to get the investors to give up those claims. They get something for their money.
Think about borrowing money from a bank. The bank 'gives' you money and in exchange they have a claim on you to pay them interest and eventually a return of the principle. If you pay off the loan, you reverse that transaction. You 'buy back' the piece of paper from them. Edmans says:
"This is like how an enterprise repaying debt gives cash to the bank today, in exchange for reducing the bank’s future claim on the firm – and few would argue that repaying debt is a free gift to the bank."