In two previous pieces, I examined an interview given by Aswath Damodaran, a professor at New York University's Stern School of Business, in a special report by Goldman Sachs (GS, Financial) on the issue of corporate buybacks. Damodaran is very much an orthodox thinker when it comes to corporate finance, and this is especially evident in his opinion on the practice.
In essence, he believes buybacks are an extremely efficient way of returning cash to shareholders and that they are better than the alternative, dividends. Furthermore, he believes that although buybacks (definitionally) result in less reinvestment, that money eventually finds its way to the economy.
My view is that while this is all well and good on paper, in practice executives are often faced with perverse incentives that cause them to act (on the margin) in ways that aren’t necessarily in the company’s long-term interest. For instance, the focus on earnings per share as a proxy for performance can incentivize management to juice this figure by repurchasing shares. Here is what Damodaran has to say about these kinds of critiques.
The link between share price and buybacks
Damodaran acknowledges that executives who are compensated with stock options (as many these days are) will benefit if the stock prices rises. However, he disputes the idea that buying back shares should necessarily increase the stock price:
“Of course, if buybacks automatically increase the stock price, then executives that are paid in stock benefit. But there is no direct link between buying back shares and increasing the stock price. Buybacks in and of themselves do not create value, they just return cash”.
This is strange. Yes, buybacks do not create value. But when the number of shares outstanding is reduced, existing shareholders end up owning a larger percentage of the equity of the business. The intrinsic value of the business stays the same, but the value of the individual claims to that business rises. It’s simple supply and demand.
The difference between theory and practice
Damodaran then goes on to say that management cannot pursue inefficient buybacks because doing so would damage the company long term, which is ultimately not in their own interest:
“And even if there is an initial bump in the stock price on the announcement of a buyback, if buybacks are coming at the expense of good projects and hurting the company in the process, executives are ultimately hurt as restricted stockholders.
Executives want the stock price to rise just as much as any shareholder, and doing buybacks in and of itself doesn’t achieve that; doing buybacks for the right reasons does—and all stockholders will share in those benefits.”
Damodaran is an academic, and it really shows in this passage. This kind of explanation works perfectly well in theory, but in practice it ignores the countless examples of corporate mismanagement that we have access to.
In reality, there are many scenarios in which management could choose to trade off long-term benefits to the company (which may be abstract and difficult to define) for short-term benefits to both themselves and activist investors and boards who demand share prices increase today. As the great baseball coach Yogi Berra used to say: “In theory, there is no difference between theory and practice, but in practice there is.”
Disclosure: The author owns no stocks mentioned.
Read more here:
- Aswath Damodaran: Do Buybacks Reduce Investment?
- Aswath Damodaran: The History of Buybacks
- Howard Marks: Why Do Financial Disasters Happen?
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