The efforts by boards of directors to increase shareholder value often include buying back company stock. A stock buyback (“Stock Buyback” or “Buyback”) is the purchase by a company of its own stock, either on the open market or directly from its shareholders. A Buyback is also known as a “share buyback” or “stock repurchase.” Similar to a dividend, a Buyback is a way to return capital to shareholders. While a dividend is effectively a cash bonus amounting to a percentage of a shareholder’s total stock value, however, a stock buyback requires the shareholder to surrender stock to the company to receive cash. Those shares are then taken off the market, thus having a similar effect of returning capital to shareholders.
Buybacks are a relatively new concept and were uncommon before 1982. In fact, they were illegal throughout most of the 20th century, because Buybacks were considered a form of stock market manipulation. In 1982, the Securities and Exchange Commission (“SEC”) passed Rule 10b-18, which created a legal process for executing a Buyback.
Today, in 2018, more companies than ever are buying back stock. The increase in Buybacks has been fueled by The Tax Cuts and Jobs Act passed on December 12, 2017, which substantially lowered the corporate income tax rate as well as repatriation tax encouraging money held abroad to be brought back to the United States.
The effect of a Buyback on an executive incentive program will depend on a variety of factors and is specific to each company and its unique incentive program.
The Pros and Cons of Buybacks
The Pros
Among the many positive aspects of Buybacks is that they increase stock price and thus shareholder value:
- Increase Shareholder Value: Often, a company will use a Buyback to support and in most cases increase the price of its shares when it believes they have become undervalued. The undervalued stock is bought back at the lower price, sometimes sending a signal to investors that the stock will appreciate in value. The amount of that appreciation ranges between the initial bump in the stock price caused by the Buyback and any further increase resulting from the market reaction to that initial bump.
- Return Cash to Shareholders: Buybacks are used to provide current shareholders with a cash distribution, and this is viewed as a bonus by many investors. An investor can sell stock either to the company or into the open market, where the Buyback creates strong demand.
- Provide Consistent Shareholder Returns: Buybacks provide more consistent returns to shareholders than do special cash or stock dividends, which only benefit current shareholders. This allows Buybacks to complement dividend rates, boosting shareholder returns without an increase in a stable dividend rate.
- Reduce Aggregate Cash Dividends: Buybacks provide a way for companies to reduce their cash outflow without having to cut their dividends. Fewer outstanding shares means fewer dividends to be paid, and a company may reduce its dividends by a significant amount. The present value of the reduction in aggregate cash dividends may be less than the cost of the Buyback.
- Increase Earnings Per Share (“EPS”): Removing some shares from the marketplace means annual earnings will be distributed among fewer shares, and each share will be entitled to a greater portion of earnings. The reduction of shares is somewhat counteracted by the interest earned on the cash used for the Buyback.
- Boost Capital Efficiency Measures: Buybacks can increase financial ratios used to calculate capital efficiency measures such as Return on Equity, Return on Assets, or Return on Invested Capital. Capital structure plays a large role in how companies optimize opportunities and provide cash for growth and operations. A major factor of capital structure is the debt to equity ratio. When a company initiates a Buyback, it effectively changes its capital structure, because fewer outstanding shares equates to less outstanding equity. This change in structure has the benefit of increasing a company’s capital efficiency measures, simply because its generated returns are now linked to a lower level of equity, assets, and invested capital.
- Increase Market Liquidity: Sometimes large shareholders or sellers of a specific stock are looking to liquefy their holdings, and an issuer may offer to buy back their shares.
- Offset Dilution: A Buyback will offset dilution from the issuance of shares as part of a long-term incentive (“LTI”) program.
The Cons
Buybacks may increase executive compensation levels, regardless of the success of the company. This is particularly true after the recent reduction in corporate income tax rates.
Buybacks directly influence many of the financial ratios used as performance metrics in executive LTI plans. As discussed previously, Buybacks can boost EPS, ROE, ROA, ROIC, or stock price. While growth in pay levels through the increased value of LTI payouts may benefit executives, there is bound to be criticism from investors, employees and political factions.
A key connection between buybacks and executive pay is EPS. Buybacks will reduce the number of shares outstanding, thereby increasing earnings per share. EPS is a key benchmark for an executive’s performance-based pay – particularly in LTI programs. In addition to EPS, Buybacks also affect other parts of the financial statement. On the balance sheet, a share repurchase will reduce the company’s cash holdings, and consequently its total asset base, by the amount of cash expended in the buyback. The buyback will simultaneously shrink shareholders’ equity on the liabilities side by the same amount. As a result, performance metrics such as ROE ROA, and ROIC typically improve following a Buyback.
Another issue related to executive compensation is that a Buyback generally occurs during an LTI award’s performance period, and there is no corresponding adjustment to the performance goals to offset the effect of the Buyback. So, it can be said that a Buyback gives executives a head start in achieving their performance goals.
A Closer Look at Buybacks and Executive Pay
It is true that executives in the United States will receive larger incentive payouts when measures like EPS, ROE, ROA, ROIC, and stock price show improvement (financially engineered or not). Today’s executive pay packages include a significant portion of LTI awards and rely heavily on LTI awards with performance conditions.
Our recent study[1] showed that LTI awards occupy a greater portion of total pay than ever before, up from 22.8 percent in 2010 to 36.7 percent in 2016 in the Russell 3000 and from 32.0 percent to 47.4 percent in the S&P 500.
Another recent study[2] showed that a majority of executive LTI awards at large cap companies are tied to performance measures, including stock-price- or EPS-related measures. Among the Top-200 companies by market capitalization, performance-based LTI awards first averaged 50 percent of the total LTI grant value back in 2012. By 2015, performance-based awards had increased to 59 percent of the total LTI grant value.
We found that midmarket companies have also moved towards LTI programs focused on performance-based awards[3]. In 2016, those awards made up 48 percent of the total LTI grant value among these companies, up from just 39 percent in 2014. This midmarket sample includes 100 companies selected at random from the Russell 3000 and included companies across multiple industries with annual revenues between $1 billion and $5 billion (nonfinancial companies) or assets between $1 billion and $10 billion (financial companies).
In 2016, the majority of mid-market companies set LTI plans based on income-related measures like EPS (64 percent), followed by total shareholder return (“TSR”) at 56 percent. Among the top 200 companies, the use of income-related measures in 2015 held strong at 51 percent.
Among midmarket companies, capital efficiency measures (where results are divided by capital to assess the quality of the company’s receivables) grew in usage from 23 percent in 2015 to 27 percent in 2016, while revenue measures grew in usage from 18 percent to 21 percent over the same period. However, the use of both capital efficiency and revenue measures remained stagnant from 2013 to 2015 for top companies.
ENDNOTES
[1] CEO and Executive Compensation Practices: 2017 Edition (https://www.conference-board.org/ceo-executive-compensation/)
[2] Gallagher’s 2015 Study of Short- and Long-Term Incentive Design Criteria Among Top 200 Companies (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2916206)
[3] Current Trends in ‘Mid-Market’ Incentive Plan Design (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3152287)
This post comes to us from James Reda, managing director of executive compensation at Arthur J. Gallagher & Co. It is based on his recent article, “Executive Compensation and Stock Buybacks: The Pros and the Cons,” available here.