In this morning’s Financial Times, columnist Tony Jackson, an interesting and insightful reporter, writes about corporate stock buybacks. He observes that in today’s world company buybacks tend to “not only respond to the ebb and flow of the markets, but also amplify them.” Firms tend to buy a lot of stock when the price is high and only a little when the price is low. In contrast, the “rational approach” would be to buy low and sell high.
Tobin’s Q ratio
Although Mr. Jackson doesn’t mention the Yale economist James Tobin, his “rational approach” is a restatement of Prof. Tobin’s Nobel Prize-winning work, best known by the term “Q-ratio.” According to Tobin, corporate managements know better than anyone else the intrinsic value of their companies. Savvy CEOs issue stock when the quotient (the “Q”) of market value of the firm/intrinsic value of the firm is greater than 1. They buy stock back when the ratio is below 1.
Based on this criterion, the tendency of companies to “buy high” and the practice of making acquisitions for stock and then buying back in the open market the same number of shares just issued (one of these actions must be wrong) make no sense. I think there’s a method to the madness, however, even though it may make no Q-ratio sense:
1. In the US at least, if you sell your company to an acquirer, it can make a big difference whether you take stock in the acquirer or cash for your shares. If you sell for cash, you owe capital gains tax on the transaction in the year the deal occurs. If, on the other hand, you trade your shares for equity in the acquirer, the IRS considers that you are maintaining your equity holding. True, tax will eventually be due when you sell the new shares for cash, but an equity swap allows you to postpone the taxable event, or even spread it out over a number of years.
In cases where this is an important consideration for the seller–that is, any time the capital gains tax for controlling shareholders (or management) would be large–a share swap will cost the acquirer 10% or so less than an all cash deal. Buying back on the open market the same number of shares issued in an acquisition may not be the most brilliant use of corporate cash, but it’s not clearly irrational, either. It makes the transaction a synthetic all cash deal.
2. Some companies may repurchase stock because they see it as the best use of their funds. For most, however–be warned that this is a pet peeve of mine–I think the real relationship is between stock buybacks and the exercise of stock options held by company employees.
Stock buybacks offset the dilution from stock option exercise. The effect of this activity, if not the intention, is to conceal the (potentially large) portion of management compensation that comes from awards of company stock.
In my experience, smaller entrepreneurial companies talk the most openly about the key role that transfer of a certain percentage annually of the company’s equity away from existing shareholders and into the hands of management plays in keeping highly-talented people as employees. The target may be 2% of the firm’s equity. During the internet bubble I heard numbers as high as 8% bandied about.
No matter what the target, issuing large chunks of equity to management may not go down well with the current owners, whose percentage ownership is being diluted. By buying back enough stock in the open market, and thereby keeping the annual share count stable, the extent of the ownership transfer becomes less noticeable.
3. By the way, going back to Tobin’s Q, it’s always amazed me how many Nobel Prizes have been awarded to financial economists for academic formulation of the common sense nostrums of pre-World War II professional investors.