The 2020 Coronavirus Aid, Relief, and Economic Security (CARES) Act introduced a ban on stock repurchases and dividends for firms receiving stimulus loans. This ban is set to expire in September 2022. The ban was included in the stimulus package to stabilise the labour market. The President of the Association of Flight Attendants Sara Nelson now calls on the extension of this ban for airlines to help fix operational issues this industry is still facing. In this column, I summarise what we know about buybacks from recent research and highlight facts that are often ignored by the critics of share repurchases.
How do share buybacks work
In a share buyback, a company chooses to purchase its own shares from shareholders, and it takes these shares completely from the market, which lowers the number of shares outstanding. This will, at least temporarily, increase the reported earnings per share because you are dividing the same earnings by a lower number of shares outstanding.
The history of stock buybacks
Share buybacks have been growing steadily over time. They now represent a dominant form of corporate pay-outs to shareholders. Since 1997, more money was returned to shareholders through buybacks than traditional dividends.
Why have stock buybacks become so popular? It’s mainly because of the flexibility they offer to firms and investors preferring to be paid in buybacks over dividends. Buybacks offer tax advantages. Repurchases face a lower tax burden than dividends because they allow for greater deferral of capital gains.
When are firms choosing share repurchases?
Having an option to pay shareholders in dividends or stock repurchases provides firms with greater financial flexibility. Dividends and buybacks are used in different times. Dividends are paid by firms using stable and permanent operating cash flows. Stock repurchases are, on the other hand, used by firms with higher temporary non-operating cash flows (Jagannathan et al. 2000). Stock repurchases represent a more variable component of shareholder cash flows that reacts to temporary shocks and firm needs. Managers also repurchase shares from the public when they view their firm as being undervalued (Ikenberry et al. 1995).
The impact on financial markets
Recent research shows that share repurchases make prices more efficient and reduce idiosyncratic risk of firms (Busch and Obernberger 2017). Using buybacks helps firms maintain prices closer to fundamental values and improves firm liquidity (Hillert et al. 2016).
The negative side of buybacks
Repurchases can be either myopic, when funds are taken away from valuable projects, or efficient, when financed by cash that would have been wasted otherwise (Edmans et al. 2017). Most critics say that money spent on share buybacks could have been spent on maintaining work force, innovation, or new job creation. Recent research (Almeida et al. 2016) shows that firms that would just miss their earnings per share (EPS) forecast are more likely to buy back their shares to boost their earnings per share. Repurchases that are motivated by EPS boosting are linked to reductions in employment and investment as well as a drop in cash holdings.
Some critics further argue that share buybacks are used to manipulate stock prices. There isn’t enough evidence substantiating these claims. Strikingly, Busch and Obernberger (2017) find the opposite to be true – share buybacks increase price efficiency.
Why now? Why have share buyback volumes been so high in recent years?
Firms sit on a lot of cash. Take Apple as an example: the company spends the most money on share buybacks by far. Apple spent an enormous $67 billion on stock repurchases in 2019. This is almost the same amount of money as their total annual operational cash flows, which was $69 billion in 2019. Apple also paid dividends in the amount of $14 billion over the same year. Apple covered these pay-outs by selling investments worth almost $100 billion in 2019.
An important contributor to the prevalence of share buybacks in recent years were low interest rates and recent tax cuts. A majority of corporate tax savings from the tax cut in 2018 have likely gone to buybacks and dividend pay-outs. The low-interest environment and quantitative easing policies of the past decade were making it substantially cheaper for firms to issue new debt and repurchase stock at a larger scale. Quantitative easing does not always increase investment because it can make term premia to become negative, which incentivises firms to issue debt and repurchase stock (Farrant et al. 2014).
Firms choose to pay their shareholders back when cash is easily available and, at the same time, there are not enough business opportunities, in terms of investable projects such as research and development (R&D), buying other companies, or spending more on other capital expenditures.
Share buybacks in the airline industry
The common perception of the public is that, before the ban, all airlines were using share buybacks extensively at the cost of suppressing capital expenditures and business investments.
Are airlines really that bad in terms of money spent on buybacks?
Let’s compare the total annual net income (in grey bars) with net stock repurchases of firms from various industries. I display the airlines industry, industrials without airlines, information technology (IT), and consumer discretionary in the figure below.
Figure 1 Stock buyback volumes versus net income
Notes: This figure shows cash flows of firms in the Airlines (GIC 20302010), Industrials (GIC 20) without Airlines, Information Technology (GIC 45), and Consumer Discretionary (GIC 25) industries. The grey bars represent the net income of the entire industry. Industry stock repurchases (new issuance of stock) are highlighted in solid black (dotted blue) line. Net stock repurchases, i.e. the difference between the volume of stock bought back and stock newly issued by firms, are in dashed red. The green dashed-dotted line are total dividends paid. All values displayed represent total sums across all firms in a given industry, in billion dollars.
The net income of airlines has been substantially more volatile than in most other industries. Airlines have used their cash flows to repurchase shares in years of high profits between 2014 and 2019. Airlines do not pay much to shareholders in dividends. This is understandable considering how much their net income varies over time. Stock repurchases, therefore, represent a more convenient tool how to reward shareholders investing in the airline stock.
Figure 1 reveals that airlines are not using stock repurchases more than other industrial firms or IT firms. It’s quite the opposite, in fact. IT firms have led the trend of stock buybacks over the past decade and continue to be the driving force behind the large volumes of stock bought back from shareholders. Firms in the consumer discretionary industry have also used stock buybacks extensively in the past 20 years. All the three industries displayed in Figure 1 and compared with airlines are shown to be using stock repurchases in a similar fashion (if not more intensively) than airlines. In contrast to airlines, other industrial, IT, and consumer discretionary firms also pay relatively stable dividends each year.
The airline industry is unique due to its overall lower firm concentration and relatively high market power. Airlines are usually not allowed to spend their cash on buying other firms and do not engage in R&D or other similar investable opportunities. Consequently, using stock buybacks seems to be an ideal way to spend excess cash that may not be permanent and, thus, cannot be easily used on persistent capital expenditure such as strengthening the labour force.
The ban on stock buybacks as part of stimulus relief for airlines
The 2020 CARES Act prevented airlines from using their cash to repurchase shares or pay dividends for at least a year after the received loans are repaid. When the federal government was determining conditions for bailouts and financial grants, it was reasonable to restrict share buybacks to provide immediate relief of stress in the labour market. The question that now remains is whether the share buyback restrictions should continue to exist in the financial markets.
Given all the existing evidence of the positive impact share repurchases have on financial markets, it is difficult to justify the existence of a ban on share repurchases in any industry. When we are considering firm cash flows from firms’ new operations, it is no longer advisable to be forcing all companies (either airlines or any other firm) to be spending their cash in the same way.
The US has the most developed and efficient public equity sector, which through shareholder investments helps allocate wealth into firms that offer the best investment growth opportunities. Restricting firms in how they can reward shareholders for their investments would have a negative impact on economic growth.
Extending the ban on share buybacks would mean that firms cannot use share buybacks and must switch to traditional shareholder pay-outs, i.e. dividends. This ban is, by itself, not going to help fix the fundamental reasons why firms choose to use share buybacks. It also doesn’t ensure that firms will use the money that may come from temporary cash flows to reinvest it within a firm.
Rather than banning buybacks, my recommendation is to focus on proposing a policy focused on improving market competition, creating new business investment opportunities, and innovation.
Aghion, P, J Van Reenen and L Zingales (2013), "Innovation and institutional ownership", American Economic Review 103(1): 277-304.
Almeida, H, V Fos and M Kronlund (2016), "The real effects of share repurchases", Journal of Financial Economics 119(1): 168-185.
Busch, P and S Obernberger (2017), "Actual Share Repurchases, Price Efficiency, and the Information Content of Stock Prices", The Review of Financial Studies 30(1): 324–362.
Edmans, A, V Fang and A Huang (2017), “The long-term consequences of short-term incentives”, VoxEU.org, 7 November.
Farrant, K, M Rutkowska and K Theodoridis (2014), “What can company data tell us about financing and investment decisions?”, VoxEU.org, 9 February.
Gutiérrez, G and T Philippon (2018), "Ownership, concentration, and investment", AEA Papers and Proceedings 108: 432-437.
Hillert, A, E Maug and S Obernberger (2016), "Stock repurchases and liquidity", Journal of Financial Economics 119(1): 186-209.
Ikenberry, D, J Lakonishok and T Vermaelen (1995), "Market underreaction to open market share repurchases", Journal of Financial Economics 39(2-3): 181-208.
Jagannathan, M, C P Stephens and M S Weisbach (2000), "Financial flexibility and the choice between dividends and stock repurchases", Journal of Financial Economics 57(3): 355-384.