What Investors Need to Know About Stock Buybacks

Stock buybacks are deceptively complex. (Perhaps this mystery adds to their allure among CFOs!) Shareholders should be particularly concerned because a recent report suggests that buyback confusion also extends to the board room.

Ever since the SEC loosened its regulation on buybacks, companies have been changing the way they distribute cash to shareholders. By McKinsey’s calculations, share buybacks have increased to about 47 percent of the market’s income since 2011, up from both about 23 percent in the early 1990s and less than 10 percent in the early 1980s.

A recent report¹ sponsored by the IRRC Institute, highlights interviews with 44 directors serving on the boards of 95 publicly traded U.S. companies and their perspectives on stock buybacks. One concerning conclusion from this report is that directors may view share buybacks as a method of covering up the unfavorable aspects of stock options.

The report’s author, Richard Fields, shared that he was struck by how universally accepted the assumption is that equity compensation should be offset by buybacks. For example, one director reported, “I believe you always buy stock back to offset dilution that comes from granting options. You do not want to dilute the current shareholders.”

Wait—hold on. This is terrible reasoning. Buybacks don’t offset the dilution of share value (caused by granting options). Assume with me that ACME Corp. has two shares of stock before awarding its CEO one share of stock as a reward for hitting growth targets. In our overly simplified example, adding an additional share increases the total outstanding shares to 3 and reduces the value of each existing share 33%.

Here’s how buybacks work. Now assume that ACME Corp’s market value is $300 and the corporation uses excess cash to purchase one of the existing shares with the aim of destroying this share and reducing its overall shareholder count. After the repurchase is complete, there are two remaining shareholders and the corporation is worth $200 (after $100 was distributed). In this example, the remaining investors are no better or worse off than before the buyback. They still own one share of stock and each share retains its original $100 value. The purpose of the buyback is to enable ACME to slim down by distributing cash that’s not being put to productive use.

stock option and buyback

Equity compensation is a very effective tool, but it’s naive to believe that buybacks can shelter shareholders from its costs. Another director quoted in the IRRC study shared this: “If we are using hard dollars to offset stock dilution, we should treat those hard dollars as a compensation expense. Otherwise we are not recognizing what we are actually spending to compensate our people.”

Corporations have many good reasons to pursue an equity buyback strategy, but camouflaging executive pay isn’t one of them.

¹Buybacks and the board: Director perspectives on the share repurchase revolution