These days you hear a lot about “enhancing shareholder value”. That is, managements of many firms want their shares to perform well. Management, of course, has a fair bit of self-interest at heart in deciding how best to accomplish this. Fortunately, when managers think like shareholders, you win.
Most firms want to see the price of their shares rise. After all, managements’ interests are often aligned with those of the shareholders. Many key executives, for example, receive stock options and other compensation tied to their firms’ share prices. As a result, they make more money if the shares go up—which helps shareholders.
A second reason is that managements are now more vulnerable due to the rise of institutional investors. Many firms are controlled by a few big institutions. This gives the institutions a lot of voting power. If a firm’s shares fall, it drags down the institutions’ performance. This can result in the money managers losing their jobs. As a result, they put pressure on firms to fire executives who do little for the share price.
So, while every firm wants its shares to do well, there’s disagreement about the best way to accomplish this. One disagreement concerns dividends and buying back shares. Some think rising dividends push up share prices. Others think share buybacks do a better job.
Over time, rising dividends supported by rising earnings drive up a firm’s share price. After all, an ever-rising yield attracts income-seeking investors. With every dividend hike, they bid up the shares until the yield is similar to those of comparable firms.
Others, however, argue that buying back shares is the best way to boost a firm’s share price. First, share buybacks reduce the number of shares outstanding. This usually raises earnings per share by spreading the earnings over fewer shares. Higher earnings per share usually justify a higher share price.
Second, share buybacks use up cash. If a firm’s cash earns, say, three percent, it drags down the firm’s returns. By buying back shares, firms get rid of cash and its depressing effects on their returns.
Share buybacks are more flexible than dividends
Third, share buybacks give firms flexibility. Writing in The CFA Digest, Chartered Financial Analyst Robert A. McLean says: “when excess equity seems to be a temporary condition, share repurchases allow the firm to distribute cash to shareholders without increasing the cash dividend, which investors may consider to be a permanent change.”
Then again, one could argue that paying “special dividends” is just as effective as share buybacks in using up extra cash.
Fourth, McLean writes that: “Share repurchases improve ROE (return-on-equity) as long as prepurchase earnings per share are greater than the after-tax interest rate on the debt that is issued to make the repurchase. The effect of share repurchases on ROE is greatest when shares are undervalued.” In fact, firms sometimes feel buying back shares is the most profitable investment they can make, especially if the share price fails to reflect a firm’s profits.
Fifth, taxes favor buybacks. Interest paid on debt, for example, is deducted from a firm’s profits before taxes are assessed. McLean writes: “As a substitution of debt for equity financing, it (a share buyback program) can reduce tax expense.” The other thing is the federal government’s tax cuts for capital gains. By paying taxes on half of capital gains, investors keep more after-tax dollars from capital gains than from dividends. To the extent that share buybacks lift share prices, shareholders benefit more.
Sixth, share buybacks raise the demand for the shares in the stock market. Continuous buying lends support to the share price.
The benefits outweigh the drawbacks
Finally, when management says it wants to buy back shares, it’s telling the market that its shares are undervalued. Even if the firm doesn’t buy back any shares, this can have a positive effect on the share price. Short sellers, for example, will think twice if they fear a firm might drive up its share price.
At the same time, McLean points out that: “The added value from repurchases comes at the expense of greater volatility in earnings per share, a result of the increased leverage. That increased risk may be reflected in lower credit ratings.” In addition, less equity worsens the debt-to-equity ratio.
Our advice remains that you should compete in the market with firms that buy back their shares. The benefits of share buybacks outweigh the drawbacks.
The Investment Reporter, MPL Communications Inc.
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