When companies buy back their shares, as AIB did two weeks ago, it’s common for them get stick for it. You’d expect criticism of the practice from The Guardian, but even the Harvard Business Review is piling on.
Their argument goes like this: it’s bad when companies buy their own shares back because it’s money that could have been used for wages or investment. The argument is that buybacks reduce wages and investment, so they’re bad for society.
But buybacks are good for investors. And more importantly, they’re good for society.
A company is doing a good job when it’s maximising its value. Obviously that’s true from the perspective of the company’s shareholders. But it’s true for society too.
When a company is maximising its value, it’s combining a bunch of inputs like land, labour and machinery in such a way that the whole is more useful than the sum of its parts. Society gets more value from a bakery than it does from flour, workers, vans, ovens and land. The extra value created for society is reflected in the value of the combined entity, relative to the value of the separate inputs.
In 1990, Grand Canal Dock was an industrial area. But then, the economy changed, and Ireland needed lots more offices near the city centre. Whereas in 1990, the best combination of resources at Sir John Rogerson’s quay was an oil storage tanker, today it’s the glassy office of McCann Fitzgerald law firm.
The oil distributor sold the expensive land on the quays and moved to the edge of the city where land was cheaper. The law firm bought the expensive land on the quays and established a valuable business, within walking distance of its clients. Shareholders of companies maximised their value. Ireland as a whole was made better off.
So the principle that companies should try to maximise their value is generally sound. In our society, there are infinite potential combinations of resources. When thousands of companies go around maximising their value, it ensures resources are combined as usefully as possible.
Where do buybacks fit in? Buybacks are part of the three big decisions a company makes when maximising its value.
The first decision is: how much should the company invest? This comes down to a simple calculation: the return a company expects to make on its investment, and the cost of the money it uses to fund the investment. If the expected return is higher than the cost of the money, the company should invest. If the expected return is lower than the cost of capital, the company shouldn’t invest.
For example, I wrote about Asimilar last month. Asimilar was an investment company that took money from stock market investors and used it to buy stakes in dozens of other technology companies. There was a time in 2021 when it was worth £93 million and investors were very happy to fund it. But investor sentiment turned against it, and now it’s worth just £1 million. It won’t be making any more investments for the foreseeable future because its cost of funding has risen so much.
The second decision is over how to fund the company — what blend of debt and equity? I’ll skip over this one because it’s not very relevant to buybacks.
The third question is about how much money to give back to shareholders, and in what form. This is where buybacks come in.
Say you’ve got a company that made profitable investments in the past. It opened ten burger restaurants and the restaurants are making bank. But it has run out of good places to build restaurants, and the expected profit from opening an eleventh restaurant is less than the amount investors would charge to fund its construction.
All companies eventually reach this state. They run out of investment opportunities. Their original Big Idea stops working.
Faced with this prospect, a company can do three things. It can give money back to shareholders in the form of dividends or buybacks. It can deny reality, and plough money into more unprofitable burger restaurants. Or it can try to roll back the clock and reinvent itself. It could spend a tonne of money rebranding itself as a coffee chain, in the hope of finding a new growth formula.
In this scenario, giving money back to shareholders is good for shareholders. After all – it’s their money. It’s better to give it back to shareholders because, what do the burger people know about running coffee shops? Why would they be better placed than anyone else to do it?
Finally I get to the point: the reason buybacks and dividends are good for society is because they are the mechanism through which new investments get funded. Old companies that have run out of ideas give money back to investors; the investors give the money to new companies with new ideas. Eventually, the new companies run out of things to invest in and the cycle continues. Like the water cycle.
How do buybacks differ from dividends?
What about buybacks specifically? Are they different to dividends, somehow more objectionable? The answer is: not really. A dividend is a stream of cash payments. It’s usually pretty stable because it looks very bad when a company cuts its dividend. A special dividend is a once-off cash payment. And a buyback is where a company uses extra cash to reduce the total number of shares.
Buying back shares has the effect of increasing the value of the remaining shares, since there are fewer claims on the company’s future cash flows. Buybacks are increasingly popular, relative to dividends, for two reasons.
The first is tax. In Ireland, dividends are taxed at a different rate to capital gains. In Ireland, most investors pay 53 per cent on their dividends and 33 per cent on capital gains. This gap exists in most countries.
The second is flexibility. As we’ve seen, companies don’t like to cut their dividends. Dividends are expected to be reliable, so it sends a bad signal when a company cuts them. In practice companies keep paying them, even as they circle the drain. You’ll find dodgy companies trading at yields of six, seven and eight per cent — beware of them.
Buybacks in practice
There is another model — a capitalist society that isn’t keen on the idea of companies giving money back to shareholders. That place is Japan. In Japan, shareholders don’t have a strong say over how companies are run, and company managers tend to hoard money rather than hand it back to shareholders.
Japan is a fine country. But a problem it has is it’s not very dynamic. The economy is dominated by big old conglomerates that date back, in some cases, hundreds of years. These giants own lots of land and hoard lots of capital. It’s a good place for big stodgy old companies, but not a good place for new ones. For ordinary Japanese people, it has led to gradually declining living standards, as the old companies’ power gradually ebbs away.
The point is, when a company does a dividend or a special dividend or a buyback, that money isn’t destroyed. It’s still being invested. But instead of the company making the decision on what to invest in, the shareholder does. And the projects getting funded are outside of, rather than within, the company.
Next week, I’ll be writing about corporate reinvention. It’s hard, and sometimes it’s suicidal. But the greatest companies are masters of it.