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March 27, 2018 at 03:05 PM
Share buybacks are a hotly debated topic during this economic expansion and bull market. Many are worried that the Republican tax cuts will further exacerbate growing wealth inequality, particularly as the majority of the benefits will be returned to shareholders in the form of increased stock repurchases.
This has led Democrats in Congress to introduce a bill that would prohibit corporations from buying back their own shares. Sen. Tammy Baldwin, the Wisconsin Democrat who introduced the bill, said, “The very partisan corporate tax bill has fueled a surge in stock buybacks that is hurting economic growth and shared prosperity for workers.”
This line of thinking misrepresents how share buybacks work and the impact they have on the stock market. You would never hear politicians complain about corporations paying out dividends but, in many ways, share buybacks are simply dividends in disguise. When dividends are paid out, investors are receiving their share of corporate profits in the form of a cash payment.
The idea behind share buybacks is that by eliminating the number of shares available on the open market, the remaining investors will earn a larger piece of corporate profits. Buybacks are simply increasing the amount of profits per share available to the investor. With dividends, investors are able to allocate cash flows as they see fit but those payouts are also subject to double taxation. Because investors can always create their own dividends by selling shares, they should generally not care whether a company decides to pay a dividend or buy back its own shares.
Before the early 1980s, share buybacks were rarely used by corporations. Dividends were the main tool for returning money to shareholders. Then in 1982, the Securities and Exchange Commission created rules that made it easier for corporations to buy back their own shares without the fear that they would be subject to regulations that would charge them with manipulating their own stock price. A study from Roger Ibbotson and Philip Straehl showed that this really opened up the floodgates for buybacks:
Since the late 1800s, dividend yields have fallen dramatically, but buyback yields had huge gains after being nonexistent for the majority of the market’s history. Still, there are other options when it comes capital allocation decisions made by corporate management that can have an impact beyond dividends and buybacks. Capital can also be used to invest in future projects, research and development or mergers and acquisitions. If you look at the data, M&A activity dwarfs both buybacks and dividends, as do capital expenditures.
