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The Case Against Corporate Stock Buybacks
Implications of Excessive Share Repurchases
TL;DR: When companies repurchase more stocks than what they disburse in stock-based compensation (SBC), it often indicates a belief that internal investments in areas like marketing, sales, or R&D do not yield better returns compared to what investors can achieve independently.
From 1997, share repurchases have overtaken cash dividends as the primary form of corporate payout in the U.S., according to a 2020 report from S&P Global Research. A share repurchase, or stock buyback program, is when a company, flush with excess cash, buys back its own shares from the public market, effectively reducing the number of shares in circulation. Here are the four principal ways a company can utilize its accumulated profits:
Invest in capital expenditures such as new machinery or buildings.
Distribute dividends to shareholders.
Acquire other companies.
Execute a share repurchase program.
Before we get into why share repurchases are often problematic, let's first understand the reasons, particularly for tech firms, behind such programs - stock-based compensation (SBC). Over recent decades, venture-backed startups have increasingly replaced cash compensation with stock. Equity ownership incentives have long been used by founders to attract talent. Given that about two-thirds of venture-backed companies fail within 10 years, distributing some of the risk/reward with employees through SBC makes sense. Furthermore, as venture capital constitutes about 40 percent of U.S. stock market capitalization, this trend has permeated the public sector.
One crucial factor in the trend of SBC replacing cash comp was that until 2006 SBC was not required to be recognized as an expense on the income statement under U.S. generally accepted accounting principles (GAAP). Companies had to include the details about their SBC programs in the footnotes, but the expense was absent in the calculation of earnings. By that time, SBC expenses for companies in the Russell 3000, largest stocks by market cap, was already $25 billion. Since then, according to Morgan Stanley, SBC rose to $270 billion by 2022, or 6-8 percent of total compensation for public companies in the U.S.
So, if a company is giving out stock as compensation to employees, that has the effect of diluting the shares held by investors. This dilution lowers the value of the investor’s stock as the formula is Market Cap = Total Shares x Value-Per-Share. By issuing more shares we’re not increasing the value of the company directly, hopefully this happens overtime by compensating employees that drive up the value of the business. But before that happens, the share price should drop to compensate for the dilution.
One way to correct this is for the company to use excess cash to purchase stock from the open market, thus reducing the number of shares, correcting for the dilution. According to the National Association of Stock Plan Professionals, “...it is common for companies that offer stock compensation to employees to periodically repurchase their own stock to offset the dilution created by the equity program.” However as pointed out in an article on the Harvard Law School Forum on Corporate Governance, “Academics, practitioners, and politicians alike have maligned the use of buybacks, taking issue with their potential contribution to income inequality, underinvestment in innovation, and use for personal enrichment.” Why all the hate from folks about repurchase programs? Well one reason is that it artificially impacts one of the most important metrics used to judge the health of a business, earnings per share (EPS). According to Investopedia, “One of the most important metrics for judging a company's financial position is its EPS. EPS divides a company's total earnings by the number of outstanding shares; a higher number indicates a stronger financial position. By repurchasing its stock, a company decreases the number of outstanding shares. A stock buyback thus enables a company to increase this metric without actually increasing its earnings or doing anything to support the idea that it is becoming financially stronger.” In a Sep 2014 Harvard Business Review article titled “Profits Without Prosperity,” William Lazonick, a professor of economics at the University of Massachusetts, argued that buybacks are effectively a form of stock price manipulation.
In my opinion, if a company only purchases the amount of stock to offset the SBC, that to me seems fine.
NOTE: You can easily find the annual amount of SBC from SEC filings such as the 10-K which contains a Summary Compensation Table for top executives or the notes to the financial statements which provide detailed information about the company's compensation practices. These notes include information about stock-based compensation, such as the number of shares granted, the fair value of the awards, and the vesting schedule. In addition to these places, stock-based compensation information may also be found in the company's proxy statement, which is filed with the SEC when the company is seeking shareholder approval for a new equity compensation plan.
But if you are purchasing more than that, besides potentially manipulating the stock price, what does that signal? If we go back to that 2020 S&P Global Research report that I mentioned in the opening sentence, it states, "If a company has limited investment opportunities [emphasis added], it may distribute its excess cash flow, if any, back to shareholders to mitigate the conflicts of interest between management and shareholders. There are different ways to redistribute cash back to shareholders, including cash dividend payouts, share repurchases, or a combination of both." If you purchase just enough to offset employee compensation, that makes sense but if you repurchase more, you are giving cash back to investors, essentially a dividend. This typically signals that you don’t have a better use for that cash inside the company.
The largest investment that a tech company can make, excluding the actual infrastructure for producing goods such as cars or rockets, is in people. The two or in some cases three areas to invest in people are product & engineering (together because you shouldn’t grow one without the other), marketing, and potentially sales (if the company has sales reps). These are the growth engines for your company. I’m hard pressed to find a flywheel example from a tech company that doesn’t include reinvestment in one of these three key areas. If we look at Amazon’s flywheel that Jim Collins helped them develop it looks like this:
Lowering costs for customers which….
Increases the number of customers which……
Attracts more third party sellers which……
Leads to more revenue for Amazon to expand which……
Grows revenues per fixed costs which.....
Helps lower costs for customers which…….etc etc.
The phrase “more revenue for Amazon to expand” is where they reinvest back into their teams to market more, develop more features, etc. Another example that Jim Collins helped explain was Giro Sport Design, a cycling helmet company founded by Jim Gentes. Their flywheel looks like this:
Invent Great products which…
Gets elite athletes to use them which…
Inspires weekend warriors which…
Attracts mainstream customers which…
Builds brand power which…
Sets high prices and channels profits into R&D which…etc, etc.
Here the “channel profits into R&D” is the key investment clause for where to reinvest in people.
Consequently, when a company excessively buys back stock, surpassing the amount paid in SBC, it indicates a belief that there are no better investment opportunities within the company. This belief becomes more concerning considering that, as of 2023, public companies are required to pay an excise tax of 1% on buybacks. The message seems clear: not only do internal investments not offer a better return, they don't by at least a full percentage point.