Why Do Stock Buybacks Artificially Inflate Per-Share Earnings?

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As we all know the cavilling about stock buybacks is a nonsense perpetrated by the economically illiterate. We positively desire that money move out of old companies and into new. As both Kevin Hassett and myself have been pointing out:

If lawmakers restrict stock buybacks, that could backfire on the American economy, White House economic adviser Kevin Hassett warned on Friday. Hassett argued that buybacks are a reasonable way for companies to return excess cash to shareholders — who can then invest in faster-growing startups.
“It’s a natural way our economy recycles cash from old successful firms to new entrepreneurial firms,” Hassett told CNN’s Poppy Harlow. “If we were to stop share buybacks, or slow them down, we would be slowing down the cash flow to entrepreneurs.”

Entirely and quite so, as I’ve pointed out recently:

It’s long been known, from William Baumol, that large companies – large organisations really – aren’t all that good at invention. They are pretty hot at innovation, the incremental improvement of something we already know about and make. But that radical new thing not so much. It’s small companies that do the work there. Some part of it is just the risk aversion of large bureaucracies. Some is that by very dint of being large, an organisation is heavily invested in the current manner of doing things. But more than this, it’s not large companies that create job growth. In fact, on balance, they tend to destroy jobs as they continually become more productive in their use of labour. It’s not even small companies that employ ever more workers. It’s new ones. Given all of this well-known – in the trade that is, if not in politics – background, what we’d like is a system which does the following. Those bets on processes and products of the last generation that worked, which produce profits, we’d like that surplus to leave those organisations. We’d like it all put into the hands of those who can and will select the next big new thing. A reasonable guess as to who might do that well being those who chose right last time around – the investors who own those successes. We’d like, that is, a system whereby corporate profits were paid out to investors so they can reinvest again in the inventions which will make the future richer, those new jobs which will raise wages.

However, such is the extent of the economic illiteracy that we’ve this other contention. That buybacks artificially boost earnings per share. This is so much part of the zeitgeist that it’s not explained, or commented, it’s just stated:

Buybacks boost demand for a company’s stock and also artificially inflate per-share earnings.

What’s artificial about it? There are, after a buyback, fewer shares in issue. The profits in the company are, presumably, the same. Therefore there’s more profit per share. What’s artificial about this?

So, imagine, we keep the corporate wage bill static. But we fire a few workers, meaning that pay per worker goes up – is this artificial? Or, more accurately, we increase the minimum wage, people employ fewer workers, this is artificial?

What worries here is not that people are wrong – to err is that human thing. It’s that the error is buried so deeply in the public knowledge that it’s asserted as a basic truth. There’s nothing artificial at all about boosting earnings per share by reducing the number of shares. It’s actually rather the point of the exercise.

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Shadeburst
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Shadeburst

Buybacks are elementary Buffettology.

TD
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TD

One interesting point is that many tech companies buy in shares in part to offset the dilution caused by so many stock option exercises. An investor in such a firm might question whether executives aren’t, to some extent, using the buy backs to transfer wealth from shareholders to management. However, the shareholders don’t have to sell, and if they do perhaps they will invest in more inventive companies. I certainly don’t want Bernie Sanders and Elizabeth Warren getting involved in this.

Quentin Vole
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Quentin Vole

Yes, if you’re a CEO holding millions of options that are underwater at $9.90 but worth a fortune at $10.10, I expect stock buybacks start to look quite attractive.

thammond
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thammond

A million options is an awful lot of options. And even then if its only 20 cents each, thats not a bundle of money.

TD
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TD

In a company with a lot of options issued the executives do have an interest in keeping the total number of shares issued from ballooning. Theoretically, the value of the firm should decrease by the amount of cash used to buy back the shares, but the execs are in a better position to understand the company’s prospects which may be robust enough to offset any decline in cash balances.

thammond
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thammond

Its artificial because you want the earnings to rise, not the number of shares to decrease. That tells you nothing about the company’s performance, which is what you are interested in. Halving the number of shares doesn’t mean the business is making twice as much money, even hough earnings per share has gone up. And since you use the company’s cash nothing has sactually changed – so its artificial.