The $2.2 trillion stimulus package signed into law last week (aka the Coronavirus Aid, Relief, Economic Security Act, or CARES) has prompted an outcry from people upset at what appears to be generous provisions for Corporate America. Particular ire has been directed at executive compensation and share buybacks. Accordingly, the final legislation included language limiting dividends, buybacks and increases in executive compensation (although these can be waived on a case-by-case basis).
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The $2.2 trillion stimulus package signed into law last week (aka the Coronavirus Aid, Relief, Economic Security Act, or CARES) has prompted an outcry from people upset at what appears to be generous provisions for Corporate America. Particular ire has been directed at executive compensation and share buybacks. Accordingly, the final legislation included language limiting dividends, buybacks and increases in executive compensation (although these can be waived on a case-by-case basis).
After the dust settles on the coronavirus crisis, probably quarters away, it is quite possible Congress considers new legislation to overhaul the public health system and improve future responses to pandemics. One potential approach is requiring companies to “save” more to ensure they have more resources to weather a future crisis without taxpayer support. And restricting share buybacks could well be on the list.
Alas, while such a provision would have huge symbolic significance, it would only affect a small number of companies and do little to address other legitimate social concerns about how large companies are run. Worse, it could provide cover to avoid taking on these issues. As a thought exercise, we consider the impact that such a restriction might have on the S&P 500 and Apple (APPL), a serial repurchaser in recent years.
Why Repurchase Shares Anyway?
To briefly summarise, share repurchases reduce shares outstanding and lead to higher earnings per share and share price because net income and market capitalization, respectively, are divided among fewer shares.
Share buybacks are controversial for several reasons. Executive compensation is sometimes tied to the performance of share price and earnings per share, so buybacks are viewed as a form of manipulation. Second, many investors question whether the company would be better off investing the cash into the business.
And third, the famous Modigliani-Miller Theorem asserts that the value and earnings power of a company are independent of capital structure and how capital is returned to investors. There are several restrictive assumptions for the theorem to hold, but for our purposes it is sufficient to say many investors do not believe share buybacks enhance the value of a company.
Still, share buybacks have been popular in recent years. They are viewed a more flexible and tax efficient way to return capital to investors; and investors who hold rather than sell shares appreciate the potential boost to share prices.[1]
What if Share Buybacks Hadn’t Happened?
Our methodology is simple and intuitive. We compare actual earnings per share and share prices to a pro-forma earnings per share and share price assuming the share count is held constant as of 2013 levels. We perform this exercise for the S&P 500 and for Apple, a serial share repurchaser in recent years.[2]
Over the past 20 years, the share count used to calculate the S&P 500 index has ranged from 8.5 billion to 9.4 billion; as the number of shares rose, the EPS fell relative to holding shares constant at 2000 levels (Chart 1).
Chart 1: EPS Lagged When Shares Grew…
Source: Bloomberg, Macro Hive
Chart 2: …Then Spurted As Buybacks Rose
Source: Bloomberg, Macro Hive
Turning to the period since 2013 when share count declined due to buybacks (Chart right), EPS in 2020 is about 7% higher than EPS calculated at the higher 2013 share levels. If we assume P/E ratios were the same in both scenarios, the index is 7% higher than it would have been ex buyback; if lower earnings led to a lower P/E the difference would be greater.
On an annualized basis, EPS has grown about 6.2% per year, versus 5.2% holding share count at 2013 levels.
Apple Doubles Its EPS Growth
Now let’s look at Apple. After growing steadily for years, share count collapsed by a third since 2013 (Chart left). During that period, earnings per share grew at annualised 10% per annum, while EPS based on 2013 share count (and net income) grew a more modest 4.1% per annum. Even with the recent selloff, that differential surely goes a long way to explain why AAPL stock is up 290% since 2013 versus a pro forma 190% based on the constant share EPS. (We assume the P/E ratio is the same in both scenarios; realistically investors may award a lower P/E (and share price) for the slow growth scenario.)
Chart 3: Apple’s Share Count Dropped by a Third Since 2013…
Source: Bloomberg, Macro Hive
Chart 4: …Leading to Outsized EPS Gains
Source: Bloomberg, Macro Hive
Buybacks Are Tempting, But the Wrong Target
Obviously, we can’t know what earnings per share or stock prices would have been had there been little buyback activity over the past eight years. Despite that counterfactual, buybacks have in all likelihood contributed to high stock valuations in recent years.
If restrictions are placed on buybacks through future legislation, there is little question that will affect stock valuations especially for companies like AAPL and its high tech FANG + M brethren and some other S&P 100 companies.[3] How is anyone’s guess – they could increase dividends or try to invest the cash in their businesses. Or they might simply park it in money market funds for the proverbial rainy day – one of which we are now living through.
The impact on a broad market index like the S&P 500 will likely be much smaller, simply because buybacks have a much smaller impact on share count. Put differently, buyback activity is concentrated in a relatively small number of cashflow-rich large companies; most companies do little or no buybacks.
Therein lies the potential problem with legislation to limit buybacks. It would have huge symbolic significance but do little or nothing to address legitimate social concerns about how large companies operate. These include excessive executive pay, growing monopoly power, and stagnant worker wages. Worse still, focusing on a ready target like buybacks could provide cover to avoid taking on these issues.
[1] Dividends and share buybacks differ in two important ways. First, dividends are viewed as an ongoing commitment to investors, and companies are generally reluctant to depart from a stable dividend policy. Share buybacks, on the other hand, can be ramped up or down depending on market conditions and investment opportunities. Second, dividends are subject to double taxation at the corporate and investor level. Share buybacks are paid out of after-tax corporate dollars (or in some cases from the proceeds of corporate bond sales) while investors who sell may benefit from the lower capital gains tax.
[2] Data on market capitalisation, share price and earnings per share are readily available from Bloomberg and other vendors. Shares outstanding is calculated as market capitalization / share price (or index level). Net income can then be calculated as earnings per share times shares outstanding. A pro-forma earnings per share and share price can then be calculated based on some assumed share count.
[3] FANG + M – Facebook, Amazon, Netflix, Google and Microsoft
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)