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E-MailAlex Edmans is professor of finance at London Business School. This post is based on his recently published book Grow the Pie. Related research from the Program on Corporate Governance includes The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here); The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); Short-Termism and Capital Flows by Jesse Fried and Charles C. Y. Wang (discussed on the Forum here); and Share Repurchases, Equity Issuances, and the Optimal Design of Executive Pay, by Jesse Fried (discussed on the Forum here).
Share buybacks are one of the most controversial corporate decisions today. US Senator Elizabeth Warren claimed that “buybacks create a sugar high for the corporations. It boosts prices in the short run, but the real way to boost the value of a corporation is to invest in the future, and they are not doing that.”
That quote highlights the two main reasons why share repurchases are unpopular. First, they prevent investment—in wages, in new and better products, and in reducing carbon emissions. They seem to split the pie in favour of investors and at the expense of wider society. Second, they increase the short-term stock price, allowing a CEO to benefit by opportunistically cashing out her shares. Moreover, the CEO’s personal incentives to undertake repurchases are even broader than in Senator Warren’s quote. Buybacks increase not just the stock price but also a company’s earnings per share (EPS). That allows a CEO to hit any EPS target in her bonus contract—without boosting revenues or cutting costs, which were presumably the actions that the EPS target hoped to encourage.
The second accusation—the idea that CEOs enrich themselves at the expense of society—incites particular anger. However, in recent posts, I’ve highlighted the importance of the pie-growing mentality that’s the subject of a new book, “Grow the Pie: How Great Companies Deliver Both Purpose and Profit.” Because the pie can be grown, any gains to the CEO might be a by-product of creating value for society, rather than at the expense of society. If a CEO launches a successful new product, she personally benefits, but so does everyone else. Thus, what matters isn’t so much whether the CEO gains from buybacks, but whether buybacks help or harm long-term value—whether they grow or shrink the pie.
What does the evidence say? The UK government commissioned PwC and me to study the alleged misuse of share buybacks in the UK. Over 2007-2017, we found that not a single FTSE 350 firm used buybacks to hit an EPS target that it would have otherwise missed.
What about the long-term effects of buybacks? A seminal paper found that firms who buy back stock subsequently outperform their peers by 12.1% over the next four years. This finding is surprisingly robust—while it was on US firms in the 1980s, a recent study investigates 31 other countries and finds that the results hold in most of them. This evidence contradicts the “sugar high” concerns, but is conveniently ignored in claims that buybacks destroy long-term value.
How can these long-term gains arise? It’s an indisputable fact that any money spent on a buyback can’t be invested elsewhere—you don’t need a study to prove that—and reducing investment surely reduces long-term value?
Not always. Investment only increases value if it generates a higher return than the money could earn elsewhere. For example, a homeowner might re-roof his house, build a conservatory, and refurbish his kitchen. But after taking these investments, it may be that further home improvement isn’t worth the cost, or the money is better used for his children’s education. Similarly, a great CEO doesn’t just spend money willy-nilly, but can discern between good and bad investment opportunities. She shows restraint when she’s taken all profitable projects, and pays out the spare cash. This allows shareholders to invest it in other companies with great investment opportunities that otherwise wouldn’t be financed.
The idea that the money from share buybacks is redeployed elsewhere isn’t just wishful thinking—it’s supported by the evidence. Further studies find that buybacks occur when growth opportunities are poor and when companies have excess capital. So companies make investment decisions first and buy back stock out of surplus cash, rather than repurchasing shares first and investing only out of the scraps left over.
But the evidence is not all one-way. Buybacks can destroy value in certain cases. A study finds that buybacks undertaken to meet analyst earnings forecasts lead to cuts in employment and investment. Another paper finds that short-term equity encourages a CEO to engage in buybacks and reduces the long-term returns—but she doesn’t mind because she cashes out shortly after. Yet in these cases, the root cause of the problem is not share buybacks, but a focus on quarterly earnings and short-term pay schemes. Addressing these problems would address not only the rare instances of myopic buybacks, but other short-termist behaviours such as cutting good investment projects or failing to innovate.
4 Comments
I have no doubt the article is worthwhile and broadly accurate, but I would stress a different issue: if a company legitimately has capital to return to shareholders, shouldn’t the preferred (or required) vehicle be dividends, the traditional means of compensating shareholders? As a long-term, small shareholder, I see at most an ephemeral benefit from a share buy-back, whereas a dividend puts actual cash in my pocket to spend or invest. Buy-backs benefit active traders, and — especially — management, whose apparent numbers are improved by the artificial goosing of the stock price and share float, which is likely to increase bonuses and returns on exercised options or shares becoming unrestricted. They also benefit because buy-backs are seen as more flexible than dividends (although that’s a perception not a requirement). But all that evaporates and leaves the buy-and-hold, long-term shareholder with nothing. Forcing companies back to using dividends would make a lot of sense for individuals, and also probably pension funds, which are desperate for returns at the moment. It would also be an incentive to more stable investment, giving incentives to management to produce predictable dividend streams, to the benefit of shareholders and the overall economy.
David, thanks very much for your engagement! Actually, dividends have a big disadvantage over repurchases – they’re inflexible. Once you’ve paid a dividend, you’re implicitly committed to maintaining it the next year – if you subsequently cut it, the stock price tanks. This, it really constrains you on future investment. Indeed, in the pandemic, we’ve seen buybacks cut by 55% (providing companies with a vital lifeline) but dividends cut by only 6%. On the returns and stability point, my two articles in the WSJ aim to address that:
https://www.wsj.com/articles/why-many-people-misunderstand-dividends-and-the-damage-this-does-11591454292
https://www.wsj.com/articles/i-wrote-why-many-people-misunderstand-dividends-readers-had-a-lot-of-comments-11593944982
In the second of your wsj articles responding to questions you state: “Debt is a superior way to prevent overinvestment. First, it provides more discipline as it’s a stronger commitment—a legal one rather than a market expectation.” One wonders whether your analysis might change if in fact lenders cease to impose financial discipline – and would suggest consideration of that possibility in view of recent research by Professor Jeremy McClane, published in Reconsidering Creditor Governance in a Time of Financial Alchemy (https://journals.library.columbia.edu/index.php/CBLR/article/view/7159), which suggests that lenders are increasingly passive due to loan securitization.
All very well, and am sure PWC is hot conflicted at all…
But leaves the question – why chase stock price in the market, pay top valuations in some cases? Why not just return the money proportionally to all shareholders? If you pay a high share price you deplete the value of the company (Equity) and if stock price subsequently drops you made the remaining (longtrm) shareholders poorer. And there is always the temptation to game earnings, bonuses etc