The Mechanics of Share Repurchases or How I Stopped Worrying and Learned to Love Stock Buybacks

Abstract

Stock repurchases by issuing corporations have always been controversial and have become even more so recently because of the perception that the excess funds used to finance buybacks have come from tax cuts and other sources (such as government bailouts) that were intended to stimulate reinvestment or enhance wages and benefits for workers. As a result, critics have proposed that tax law be amended to discourage buybacks (and possibly dividends as well) on the theory that the benefits of such distributions go mostly to executives (who are compensated in large part with equity) and to already wealthy stockholders. The controversy is fueled in part by the sheer size of distributions, which are equal in the aggregate among S&P 500 companies (including both dividends and repurchases) to almost all of their operating earnings and in part by the idea that the motivation must be tax-related because corporations do most of what they do because of the tax consequences. The crucial fact missed by the critics is that almost all (95%) of the funds distributed by repurchase are reinvested by the recipient stockholders in the shares of other public companies. Indeed, stockholders are effectively required to reinvest such funds in order to generate the higher returns that one expects from equity. (Those who fail to reinvest do no better than bondholders.) For this process to work, there must be a supply of new shares in which the proceeds of buybacks can be invested. Thus, most of such funds go (1) to newly public companies or existing public companies that issue additional shares or (2) to buy stock issued by existing public companies to acquire private companies (whose sellers sell the shares with which they are paid). And some of the money goes (3) to control for dilution caused by shares issued in connection with equity compensation. The remainder is reinvested in other public companies in a continuous process that redistributes value (and thus ultimately capital) among public companies according to the prospects of each. Moreover, this process results in a chain reaction of sales and purchases by investors that has the effect of multiplying the taxes paid. So it is quite wrong to assert either that stock buybacks avoid taxes or that they result in more consumption by already wealthy stockholders. Rather, the process effectively delegates the question of where to reinvest the money to investors collectively – the market – and away from the companies that generate the return (which companies would undoubtedly tend to reinvest mechanically in their own lines of business). Indeed, it borders on miraculous that the system has evolved to induce management of the largest corporations to distribute almost all of the profits they generate rather than to retain them as was the practice as recently as the early 1980s. In short, although efforts to address wealth and income inequality are laudable, the critics misunderstand how share repurchases work and their proposals would probably make matters worse. The real worry is that we might cause companies to reinvest in underperforming acquisitions or simply to retain excess cash for no reason at all.

Keywords: repurchase, buyback, dividend, reinvestment, distribution, dilution, mergers and acquisitions, initial public offering, seasoned equity offering, equity compensation

JEL Classification: G34, G35, H25, H26, K22, K34