In defense of share buybacks

Senate Democrats are considering an array of new taxes to pay for their large budget bill. One tax being considered imposes a 2 percent tax on corporate share repurchases. It has been a rough couple of years for share repurchases. They continue to take a beating from buyback bullies on both the right and the left. How frequently do Sen. Bernie SandersBernie SandersIn Washington, the road almost never taken Don’t let partisan politics impede Texas’ economic recovery The Hill’s Morning Report – Presented by Alibaba – Democrats argue price before policy amid scramble MORE (I-Vt.) and former President TrumpDonald TrumpGraham says he hopes that Trump runs again Trump says Stacey Abrams ‘might be better than existing governor’ Kemp Executive privilege fight poses hurdles for Trump MORE agree? Buybacks are that rare instance. 

A few months ago, Sen. Elizabeth Warren (D-Mass.) derided buybacks, saying “This is nothing but paper manipulation.” An article about Warren’s remark noted a commonly held belief that “stock repurchases do nothing to improve the quality of a business or the goods and services it produces.” These commonly held beliefs in buybacks are simply false. Here’s why.

A share repurchase most often happens when a firm goes to the stock market and buys back its shares. So, what does that look like in reality? Typically, there’s a person sitting at a computer with their brokerage account open pressing “sell,” and on the other end there’s someone within a firm’s treasury function pressing “buy” at the same time. (The real mechanics are more complicated, but the substance is not.) The seller has no idea that the net recipient of the shares they are selling is the firm. The person is simply selling their shares because they want to hold cash instead of holding the stock. The person can use this cash however they please — invest it in other companies that might have more productive investment opportunities, give it to charity, give it to their kids or whatever else they want to do with it, because, after all, it is their money. The firm is simply buying its own shares on the open market, returning cash with no greater use within the firm to its shareholders.

So, does that somehow mechanically manipulate the stock price or earnings per share (EPS)? No. It is pretty easy to show that the mechanical effect of a buyback is simply to produce a smaller firm with fewer shares outstanding with the same price per share and EPS.

Let’s imagine a simple company with five shareholders, with all earnings paid out as dividends. Each shareholder contributed $1 to the firm in exchange for one share of stock, so the firm’s market value is $5. Assume the company earns a 10 percent return on its $5 of capital, so the firm generates $0.50 of earnings and $0.10 of EPS.

Now imagine the shareholders decide to have the company buy back a single share of the stock. The company takes a dollar from the corporate coffers, gives it to a…