I recently came across two interesting pieces on stock buybacks, which I’ve been meaning to cover at the Fictitious Capitalist. For those who are unfamiliar, stock buybacks—also called share repurchases—are when a company uses its own cash to buy back its shares from the open market (or directly from shareholders). Once repurchased, those shares are usually retired or held as “treasury stock,” which reduces the number of outstanding shares available to the public.

The first piece is an online comic strip from Civic Ventures called Trillion Dollar Heist. The comic is largely a paean to Biden-era policies, but does call for a ban on stock buybacks. There is some over-simplification going on in the comic and the short essay at the end, but it is still a fun read¹.

The second piece is a much more academic post on Elm Wealth’s blog about the effects of stock buybacks on shareholder value. The post argues that while, in theory, payout policy (whether through dividends or stock buybacks) should have no discernible impact on enterprise value, evidence suggests otherwise.

Dividend Irrelevance Theory and Stock Buybacks

Before we get into the details though, it would be make sense to review the theory behind buybacks. Stock buybacks are presented as a more tax efficient way of returning capital to shareholders than dividends. Warren Buffett’s company Berkshire Hathaway, for example, strongly prefers stock buybacks to dividends and in fact hasn’t paid a dividend since 1967!

Dividend irrelevance theory, however, holds that stockholders should be neutral as to the payout policy of the company, whether it is retained, distributed as dividends or used to repurchase shares. Why is that? Well, it is easier to understand when you consider dividend payouts.

Let’s say you have two companies that are, for our purposes, exactly the same in every way: Both are valued at $1 billion and have $100 million in cash with 100 million shares outstanding at a value of $10 per share².

Company A, however, decides to pay out its $100 million in cash as a dividend, while Company B decides to retain the cash for future investment. In theory, the capitalization market value of Company A should drop by exactly $100 million because the cash on the balance sheet now belongs to the shareholders. So Company A is now worth $900 million, with $100 million distributed to its shareholders, while Company B is worth $1 billion with $100 million of that value from the cash on its balance sheet.

From the investors perspective, if you owned 1% of Company A’s shares, you would have $10 million in stock prior to the dividend. After the dividend, you would have $9 million worth of stock and $1 million worth of cash (from the dividend payment), but the total value of your investments would still be $10 million—the same as if you had simply owned 1% of Company B’s stock, which never paid a dividend in the first place.

The same logic applies to stock buybacks. If Company C (with the same characteristics as Companies A and B) decides to repurchase 10% of their $1 billion of shares outstanding, they would effectively pay out $100 million in cash to shareholders, and in so doing, reduce the number of shares outstanding. The value of the company would now be $900 million, with 90 million shares outstanding, the value of which would still be $10 per share.

An equivalent investor owning 1% of the company now would own 900,000 shares valued at $9 million—having sold $1 million of stock back to the company in exchange for cash—for a total value of $10 million. Alternatively, if the investor chose not to sell their shares, letting another shareholder pick up the slack, they would still own 1 million shares worth $10 each, but would now own just over 11% of the shares outstanding.

All else equal, retained earnings, share buybacks or dividend are equivalent from the investor’s perspective, which might leave you scratching your head. Why do companies bother to distribute dividends or issue buybacks at all?

Dividends (and Buybacks) are Not Irrelevant

After a cursory review of it though, it isn’t very hard to see where the theory goes wrong. Dividend irrelevance theory relies on assumptions about the nature of markets that just don’t hold up in practice:

• Dividends and capital gains are taxed equally (not true in reality).
• Selling shares costs nothing.
• Investors know everything managers know.
• Managers always act in shareholder interests.
• The company’s real business decisions are unchanged regardless of payout policy.

The same caveats hold for stock buybacks. We already know how differences in tax treatment, trading costs, and investor and manager behavior can significantly affect company valuations. Adding share repurchases into the mix doesn’t magically turn the market perfectly efficient.

On top of that, dividend irrelevance theory assumes shareholders will passively accept the effect of dividends and share repurchases on their overall asset allocation. In reality, if a company pays out a dividend or repurchases its own stock, the investor must react if she wants to maintain the same overall asset allocation.

In the case of the dividend investor, her overall allocation to stocks has decreased, so the investor must now repurchase the stock in order to maintain the same asset allocation (this is called dividend reinvestment). A similar process occurs with stock buybacks but in reverse: investors must receive a higher price to be willing to sell their stock back to the company.

Victor Haghani and James White explain this process in depth on their blog post. For an investor with a fixed asset allocation of 50% stocks 50% cash, a 3% stock repurchase will push up the price of the stock by roughly 6%. Haghani and White further explain how different types of investors may create different pressures on stock prices—value investors, for example, may help temper these effects. There are even more complex models that suggest buybacks could push up valuations by up to 5x the repurchase amount!

Are Stock Buybacks the Problem or Just a Symptom of the Disease

We’ve spoken about finacialization of the economy recently and stock buybacks are no doubt part of that ecosystem. Evidence suggests that they may be inflating valuations, eroding the tax base, and amplifying market risks. Politically, they are also often seen as short-term actions favoring shareholders and managers at the expense of workers and other stakeholders³.

This has all led some policymakers to propose reforming repurchase law or even banning the practice altogether. Both Corey Booker and Tammy Baldwin introduced legislation in 2018-19 that would have heavily curtailed the practice if not strictly forbidden it. And President Biden’s signature legislation, the Inflation Reduction Act (IRA) of 2022 imposed a 1% tax on corporate buybacks.

The market impacts notwithstanding, a larger problem with stock buybacks is that they serve to further concentrate wealth, reducing the pool of capital and returning ownership to a select few. In that sense, they are a symptom of the disease that is late capitalism: businesses see few real economic investment opportunities, preferring to distribute earnings back to investors who in turn have no other choice but to keep buying a shrinking pool of public equities.

That said, equalizing the tax treatment of dividends, capital gains and earned income could go a long way in reducing income inequality. It is often a shock when working people learn that married couples earning all their income through capital gains could pay zero in taxes on over $120,000 in annual earnings. If capital gains were taxed at the same rate as earned income, for example, companies (and shareholders) might think twice before issuing buybacks⁴.

In the end though, a truly democratic approach to capital ownership would require socializing the means of production via the gradual transfer of ownership from capital to workers. Fortunately, we have historical precedence for this and don’t need to rely on economic theories about stock prices to ensure future wealth equality.

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Endnotes

1. The comic portrays stock buybacks as illegal prior to 1983. They weren’t technically illegal, but were risky due to anti-manipulation provisions in securities law. In 1983, the SEC adopted Rule 10b-18, which created a “safe harbor” protecting companies from manipulation charges as long as they followed certain rules. ↩︎
2. This is a hypothetical case for simplicity purposes. A healthy company would be unlikely to pay out 10% of its market value all at once. ↩︎
3. It isn’t clear to me that, in the absence of stock buybacks, companies would instead choose to make real investments in the productive capacity of their firms. They simply could choose to issue dividends, hold other financial assets on their balance sheets, or pursue rent-seeking and financialization. On the other hand, if they did reinvest in their companies, over-investment and profitability crises are dangers that cannot be ignored. ↩︎
4. In practice, it might be difficult to design an equal tax treatment for stock buybacks themselves, because stock investors have vastly different income and wealth distributions. ↩︎