An opinion piece in the Financial Times contends that the focus on stock buybacks in the Inflation Reduction Act, which imposes a 1% excise tax on share repurchases, indicates a lack of understanding of the function of buybacks and the part they play in a healthy economy.
One misperception about buybacks is that companies use their cash reserves to buy stock instead of putting it back into their business. But while many point to a drop in tangible investments as evidence of this, when taking intangible investments such as research & development into account, there is actually little proof that companies are neglecting their businesses in favor of buying back shares. In fact, reallocating capital away from businesses whose potential is limited and into those with greater potential is part of what makes an efficient economy, and buybacks help that process, the article maintains.
A second myth about buybacks is that create a short-term false high for the share price, but in reality buybacks can offer value to shareholders in the long-term as well, especially with the SEC Rule 10b-18, which prevents companies from manipulating its stock. While buybacks don’t add or take away corporate value, they can transfer wealth; when a company repurchases its own undervalued shares, those who sold miss out while those who held their stock win. If a company repurchases overvalued stock, the reverse happens, but studies indicate that companies are actually quite smart about buying low and selling high.
Yet another myth is that buybacks add to earnings-per-share (EPS), but there’s no realistic assurance of that; it’s the connection between interest after taxes and the price-earnings multiple that determines the impact buybacks have on EPS. And while some point to buybacks as a means for executives to increase their pay by bolstering EPS, the article cites a study out of the London Business School found that between 2007-2017, not a single company in the FTSE 350 hit targets that they otherwise would have missed.
Both buybacks and dividends return money to shareholders, but dividends tend to be viewed more favorably for three reasons: sorting, taxes, and attitude. Sorting refers to shareholders creating their own dividend by selling shares in the same amount that the company is buying; they wind up with cash as well as the same ownership stake. As for taxes, investors who hold their shares in a taxable account owe taxes on the total dividend amount, but those who sell their shares in a buyback only owe capital gains tax. Those who don’t sell can opt to defer their tax bill until they are ready to sell.
Many view dividends as a sacred bond between a company and its shareholders, something to be cultivated and increased over time, they tend to view buybacks as a more voluntary way to distribute leftover capital after every other bill has been paid. But while disparaging buybacks might be politically apt, understanding their use brings better financial literacy, the article concludes.