In this tutorial, you’ll learn about stock buybacks, understand the theory and reality, and see why they can create problems with incentives and corporate management, especially when there’s a recession, war, pandemic, or other crisis.
Resources:
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Table of Contents:
0:00 Introduction
2:50 Stock Buybacks In Theory vs. Reality
6:19 The Problems with Stock Buybacks
11:24 What to Do About Stock Buybacks?
14:15 Recap and Summary
Lesson Outline:
Should we blame companies like the big U.S. airlines and Boeing for repurchasing tens of billions of their own stock rather than saving the cash to prepare for a crisis, like the coronavirus outbreak we’re currently in?
And if so, should stock buybacks be banned?
The short answer is that the problem is not so much stock buybacks by themselves, but rather stock buybacks combined with other issues – such as high levels of corporate Debt, low Cash balances, and executive compensation tied to companies’ stock prices.
In theory, stock buybacks should not affect a company’s Enterprise Value or current share price, but reality often disagrees with this theory – because the stock market, like any market, has buyers and sellers.
With more buying activity, prices tend to rise, even if the buying comes entirely from the company itself.
So, companies often manipulate their stock prices higher with share buybacks, and reports from Goldman Sachs and others have verified this by looking at the equity fund inflows and outflows by segment. The “corporate” segment always accounts for the most demand.
Buybacks combined with Debt are bad news because Debt limits a company’s flexibility, even during crises; low Cash balances are also bad because it leads to few companies having enough funds on-hand to cover 6-12 months of expenses.
But the biggest issue is that if executives have options, performance shares, or RSUs, they can use stock buybacks to push up the stock price, even if they do nothing to grow the company’s real business.
This lets them “cash out” based on a short-term stock run-up, reduce the company’s Cash balance, and then run away and ask for bailouts when there’s a deep recession, pandemic, or war, and the company’s sales plummet.
One possible solution might be to ban stock buybacks altogether, but companies can still find ways to manipulate their share prices.
Another solution might be to ban stock-based compensation at public companies and require minimum Cash balances that cover 6-12 months of expenses.
Performance bonuses are OK if they are based on organic EBITDA growth, Unlevered Free Cash Flow growth, or something else that cannot be “gamed” as easily as metrics like the stock price and EPS.
The problem of high leverage is more of an issue for central banks due to their interest-rate repression and never-ending easy money; as long as that’s in place, companies will always have incentives to borrow more.
