THE BONFIRE OF BANK BUYBACKS
The chief executives of Wall Street's biggest banks made their annual pilgrimage to the Senate Banking Committee on Wednesday. The big shots from J.P. Morgan Chase, Citigroup, Morgan Stanley, Bank of America, Wells Fargo, and Goldman Sachs all dutifully agreed to fund green energy, reduce racial inequality, pay higher minimum wages, and, as one banker put it, "work with our employees to make sure their voices are heard."
There was a lot of criticism of buybacks from Senate Democrats, including from committee chairman Sherrod Brown (D-OH), and little defense of the practice from banks. In some sense, that makes sense. Over the years banks have not proved to be particularly wise purchasers of their own shares, often buying before periods of decline. These ill-timed share repurchases hurt the remaining shareholders, and they undermine one of the primary purposes of buybacks, which is to communicate the confidence of management that shares are undervalued. If the bank is constantly buying before a decline, shareholders lose confidence in such communiques.
That, however, is not the source of the complaints of Senate Democrats about buybacks. Instead, they appear to imagine that a buyback is both stock manipulation and economically destructive. While the image of a company making money just to buy its own shares may look a bit absurd at first glance, a moment's thought turns the apparent absurdity into wisdom. In the first place, the very purpose of a firm's profits is to reward its investors. Returning capital to shareholders through buybacks and dividends is the primary way investors are repaid for entrusting their funds to corporate managers.
It's also a myth that buybacks artificially inflate share prices. The main version of the myth goes like this: buybacks reduce the number of shares outstanding, so each share is worth more. It's simple, but it is also wrong, as just a bit of back of the envelope math can demonstrate.
Imagine for a moment a $1 billion company with $250 million of cash on its balance sheet and $50 million in annual earnings. Say it has 1 million shares outstanding, which would be worth $1,000 a piece. An analyst would tell you that the company is valued at 20 times earnings. But, in fact, investors really value the company's operations as worth $750 million plus its cash. So its earnings are getting just a 15 times multiple. If the company buys back one-quarter of its shares with all that cash, it reduces both its share count but also its intrinsic value. Now it is worth just $750 million, or the same 15 times earnings, with no extra boost from cash holdings. The price of the outstanding 750,000 shares will, ceteris paribus, remain exactly $1,000.
There are complications, of course, mostly stemming from the fact that the tax code allows deductions for interest payments but not dividends. That makes it possible for a dividend or buyback to ever so slightly increase the share price by increasing leverage. But that isn't stock manipulation, it's playing by the rules of the tax code that Congress wrote.
Sadly, once again the chieftains of Wall Street failed to defend themselves against the math-challenged attacks of the Democrats. It's easier for them, apparently, to agree to work to solve racial wealth gaps than to defend their actual corporate finance practices.
– Alex Marlow & John Carney
Breitbart News Network
