Thursday, July 24, 2008

Stock Buy-Backs Not The Cause Of Bank Problems

I found Eric Englund's LRC article about stock buy-backs to be quite misleading. It points to how American banks have made significant stock buy-backs through the years and how they are now in a crisis and so uses this as proof that stock buy-backs do not increase a company's value.

The problem with this argument, first of all, is that no one has really claimed that stock buy-backs will increase a company's value, at least not after the buy-backs are made. However, the key fallacy here is that maximizing a company's value is not (or shouldn't be) a self-end. No company exist for its own sake, it exist for the sake of its shareholders. Hence, what should be maximized is not a company's value (except when that maximizes shareholder value), but shareholder value. That means performing share buy-backs (and paying out dividends) whenever the marginal return of equity is lower for investments performed by the company then when investments are performed by the shareholders independently. When the return on the other hand is higher within the company no share buy-backs should be performed and dividends should be limited, while possibly even new shares should be issued.

Thus, it is an open question whether or not share buy-backs are good or not. It depends on where the money can be put into the best use. Turning now to the second flaw in Englund's argument, the specific case of American banks, how could Englund possibly claim that it would have been better if the evidently incompetent management and analysts at American banks would have had even more money at their disposal to invest in the inflated American housing market? Given how incompetent the staff (the ones responsible for investment decisions) of American banks has been, there can be no doubt that the less money they have at their disposal, the better. And that means that stock buy-backs helped limit the malinvestments created during the housing bubble and that had by contrast Englund's anti-stock buy back views been prevalent, even greater malinvestments would have been made and even more value would have been lost.


Blogger Barry Ritholtz said...

1. Stock buybacks increase a company's earnings per share (as more shares get retired) so valuation looks more attractive;

2. Buybacks imply that companies cannot find anything better to do with their capital;

3. As we have seen in the financial and technology sectors, many buybacks were executed at MUCH higher price levels; Now, these same firms are selling the crown jewels, and doing extremely dilutive share offerings to raise capital.

4. Buy high, sell low is never smart business ...

4:12 PM  
Anonymous Larry said...

I don't see how share buybacks are good for shareholder's. They are historically bought at top of cycle and leaves the company with a weak balance sheet in the downturn.
Now, if you have an Austrian view (somewhere in the company), you would be able to forecast the bubble (at least warn people of it), and the company would prepare for it by beefing up their balance sheet.

Contrary to your belief there are many companies who did just that in '06-'08.

5:48 AM  
Blogger stefankarlsson said...

Larry, I told you why they are good for shareholders. Share buy-backs are a form of dividend which allows shareholders to keep that money. If on the other hand they would have stayed in the company they would have gone lost because they under the management they had would have been invested in the mortgage market. More equity enables a bigger balance sheet and therefore bigger investments in the mortgage market and therefore greater losses.

To make a numerical example. If a bank is worth at the top say $100 billion and gives their shareholders $10 billion and the value of the bank therefore falls to $90 billion. If the stock price then falls 80% due to the housing bust then investors will be left with $28 billion ($10 billion + (0.2*$90 billion) if the company makes the share repurchase/dividend. By contrast if the bank had followed your stratedy of keeping the money then the shareholders will be left with only $20 billion.

8:12 AM  
Anonymous Larry said...

Yes in theory you are right. However, if a company sees a bubble developing it can be more prudent with cash to improve its balance sheet to for example avoid implosion and/or later on to buy other companies in the industry at bargain prices.

If you take 15 different sectors worldwide and compare the share price of say the top 50 listed companies (07-09) you will see what I am talking about.

Some companies will come out stronger into 2010 because they saw the monetary bubble and acted accordingly. They are not many, but you will find them.

10:10 AM  
Anonymous Larry said...

I see your point now. You are assuming that management don't act in the best interest of shareholders if they are left with too much cash. Or that they misread the economy or don't understand economics. You are right in 96% of instances.

10:13 AM  
Blogger stefankarlsson said...

"If a company sees bubble developing"

Yes, *if* they do it, then it makes better sense to keep the money. But the point is that they didn't, and instead continued pouring money into the American mortgage market. Under such circumstances, it is better if they distribute the money to shareholders.

9:49 PM  

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