Two Misleading Criticisms of Corporate Behavior

The recent request for bailouts by airlines and other companies has brought the subject of stock buybacks as a means of returning investors’ cash to the forefront of the national conversation. Many politicians and media members have criticized buybacks as a means of solely enriching corporate executives by boosting share prices, at the expense of the rest of the company.   However, dividends and buybacks are both legitimate means of returning profits to shareholders. In fact, a company buying back its shares can often be a better choice for the majority of its shareholders than returning earnings through a dividend. A more nuanced critique is that buybacks can advantage either the sellers or the remaining shareholders based on the price, unlike a dividend that pays all a flat rate. Companies aggressively pursuing buybacks at high valuations can destroy value for the remaining shareholders.

Consider a company that has 10 shares outstanding owned by different investors that trade for $10 each, for a market capitalization of $100. Furthermore the company has $20 of cash on its balance sheet. Suppose further that the fair value of the company, assessed as the net present value of future earnings discounted at an appropriate risk-adjusted rate, can be determined to be $80. In this scenario, the company repurchasing one share will have the same effect as a dividend of $10 disbursed equally among the shareholders. In both cases, the shareholders will each have assets worth $10. In the case of the dividend, each shareholder will have one share worth $9 and $1 in cash. In the case of the buyback, one shareholder will have $10 in cash and the remaining shareholders will still have stock worth $10.

Now suppose that shares in the company are trading at $9 and the company buys back one share at this price. The remaining shareholders benefit as the company has paid below fair value to increase their proportional holdings in the company. The fair value of each share in the company has increased from $10 to $10.11. The converse holds true if the share are trading at $11. The seller of the share benefits as the company has paid above fair value. Meanwhile the remaining shareholders have seen the fair value of their shares decrease from $10 to $9.89.

In the real world, the fair value of a company is obviously not known and can only be estimated. However a proper reform of corporate finance should require companies to justify their own valuations before pursuing buybacks at any price. The populist critique of buybacks paints them solely as a method of enriching executives, while dividends return cash to all shareholders. This is fundamentally mistaken, as the above examples show. Buybacks when stocks are undervalued actually provide the remaining shareholders with higher returns than dividend payments. However, the criticism does contain a kernel of truth. Buyback programs initiated when stocks are trading at high valuations may not be justified and could be used for ulterior motives, such as juicing earnings per share or triggering stock options used for executive compensation. Proper corporate governance reform will seek to return more power to shareholders for them to seek the best course of action.

One broader point of critics has been that companies have used their profits inefficiently. Rather than invest profits back into the firm or accumulate cash on the balance sheet for a rainy day, they have distributed profits back to shareholders. This has left them unprepared for the current crisis. For one, a bevy of new investment would not have helped companies meet payroll or pay their rent with their revenues severely diminished by this crisis. More broadly, increasing corporate cash balances in the aggregate must be offset by dissaving in the rest of the economy. To see why, consider that the total sum of savings in the economy must equal the amount of investment. Any saving which is not used productively, such as stuffing dollar bills in a mattress, is zero-sum as it must be offset by dissaving by another individual, the money must come from somewhere. Now savings in the economy can be broken down into four categories: household savings (HS), corporate savings (CS), government savings (GS), and savings by the rest of the world (RS). The government saves by running budget surpluses and the rest of the world saves by running trade surpluses. This gives the following identity:

            HS + CS + GS + RS = Investment

Now the corporate sector holding more cash is not an investment, thus must be offset by dissaving by households, the government, or the rest of the world. This will result in either higher household debt, the government running bigger budget deficits or a larger trade deficit. The most palatable of these options is running a bigger budget deficit, which the government is currently doing to stabilize the corporate sector. Thus critics of the bailouts must contend with the fact that the best way to stabilize corporate balance sheets was for the government to have run bigger deficits in the past. Fundamentally, the idea that we can collectively save for recessions is mistaken. One person’s spending is another’s income, so collectively cutting back on spending to save for the bad times tomorrow will bring about a recession today.

While this post seeks to address some misconceptions regarding corporate governance, I do not seek to absolve companies of their behavior before this crisis. Shareholders that were justly rewarded with dividends and buybacks before the crisis must now take any losses. Companies that rewarded shareholders instead of paying down debt must now face the impact of their decisions. However, it is the job of government to handle existential risks. Seeking to punish companies by letting them fail outright will catastrophically affect the economy. The recent CARES act alleviates this situation by letting the Fed lend directly to companies, using the Treasury as a backstop for any losses. The government should take equity stakes in companies to dilute existing shareholders and cease any dividends or buybacks during the lifetime of these loans. This will prevent shareholders from benefiting from bailouts while ensuring the long-term viability of businesses and preventing any further value destruction during this difficult time.