Share Buybacks Review for Directors – Their Economic Drivers, Psychology and Results by Philip Arnold of Excellence in Learning

Share Buybacks Review for Directors

This article is  aimed at directors and the board of directors, it is an overview of share buybacks. This author has also been published on the Institute of Directors’ (IoD) website as a lead article their August 2020 Governance section.

Share buybacks are hugely important in the USA.  They totalled $800bn per year in 2018 & 2019 according to J.P. Morgan. Although widely used in the USA, they are much less common in Europe, with Royal Dutch Shell and Unilver being notable exceptions.

Even Royal Dutch Shell has suspended its share buyback program in the wake of Covid-19.  In fact so many industries have been badly hit by the economic impact of the corona virus in 2020, that their lack of liquidity (cash) has become a major issue.  This has forced many companies to seek state aid.  Many of those countries have made the suspension of dividends and stock buyback programs, a condition of that aid.

Share buybacks are just one way in which the board directors of companies might choose to return cash to shareholders.  The other and much more common approach, especially within the UK and the EU, is through dividends.  There is no reason why companies cannot pay shareholders dividend as well as distribute cash through extensive share buyback programs.

Why do so many US companies operate share buyback programs? In part, the reason is psychological. The Stock Market focuses on Earnings Per Share, EPS, especially in the United States, but also in the UK. EPS is a widely followed measure and any increase in the EPS of a company is treated as though it were an increase in the overall profits of the company, even though those total profits may be unchanged:

  • Buying back 10% of a company’s shares will increase its EPS by 11%; 100/90=1.11

In this case the EPS has increased by 11%, whilst the total profits remain constant.  The logical implication of the reduction in share volumes by 10%, would be to increase the share price by 11%.

However, the psychological impact of the 11% EPS increase and the consequent 11% increase in share price, creates a stock market purchase momentum, that carries the share price upwards beyond the logical 11% share price increase.

The logical arithmetical 11% share price increase, causes more investors to focus their attention on that company and there may also be a tendency upon the part of some of those investors to misinterpret that 11% share price increase and attribute it to other unknown factors.  To avoid missing out, some investors will try to catch and ride the upward price wave.  Thus pulling more money and hence demand into chasing the limited supply of that stock, which would further serve to increase its share price.  Also share buybacks tend to signal that the directors of a company believe that its stock is undervalued.

There are many other practical commercial reasons why some boards of directors prefer share buyback programs to dividends.  Many of them operate extensive buyback programs that often span many years.

Share buyback programs provide more flexibility than dividend policies.  The Markets will penalise dividend cuts more than they reward dividend increases; but they tend not to punish decreases or suspensions of share buyback programs.  In addition credit rating agencies treat dividends as fixed charges when they evaluate future cashflows and assign credit scores

In general terms, share buybacks are deemed to be capital transactions and in most countries are subject to more favourable tax treatment than dividends, which are deemed to be income transactions and subject to the harsher income tax assessments.

Critics of share buyback programs often argue that they indicate that the board of directors has run out of ideas and are weakening their companies by removing much needed liquidity.    However, the evidence does not support that view.  According to J.P. Morgan the stocks of companies that buy back their shares tend to outperform their sector benchmarks, over both the short and the long term.  At the same time “Corporate buybacks have returned $5 trillion to shareholders since 2009,” said Jan Loeys, Head of Long-term Strategy at J.P. Morgan.  This would have released valuable cash for investments elsewhere.

Share Buybacks Review for Directors. To understand more about the Balance Sheet and how EBITDA and liquidity are calculated, please click the following link: Learn more about Board Level Finance

Or visit the Professional Directors Association