The Case Against Restricting Stock Buybacks

Are stock buybacks as bad as they’re made out to be? The ubiquitous corporate practice of repurchasing shares has been the focus of much political and media scrutiny. The federal Inflation Reduction Act of 2022 included a 1% excise tax on repurchases (which President Biden has proposed increasing to 4% in his 2024 budget). In addition, senior Democrats have shown interest in barring executives from selling shares for three years after a repurchase, the federal government has suggested that companies that give up buybacks will receive preferential treatment, and the Securities and Exchange Commission has proposed a significant increase in the extent and frequency of repurchase reporting.

The debate on the economic consequences of stock buybacks has so far tended to focus on small samples or cherry-picked examples. Given that thousands of companies repurchase their shares each year, and aggregate repurchases have exceeded $500 billion annually for the past five years, we decided that a large-sample study of repurchasing behavior was warranted. Our study, published in the journal Financial Management, outlines the benefits of the practice, as stated by its proponents, and provides evidence that casts doubt on the alleged costs cited by its critics.

Critics of buybacks typically make three arguments against the practice. First, they claim that share repurchases enable companies to manipulate the market either by increasing the demand for — and therefore the price of — shares or by tricking naive investors by inflating earnings per share (EPS). Second, they allege that share repurchases enable insiders to benefit through compensation contracts or the sale of shares at inflated prices. And lastly, critics charge that share repurchases crowd out investment and thus sacrifice innovation and long-term economic growth.

Meanwhile, those who support or engage in stock buybacks offer several justifications for the practice. First, payouts to shareholders align manager and shareholder incentives by reducing the potential misuse of free cash flow. Second, using repurchases instead of or in addition to dividends gives corporations flexibility in the amount of cash returned to shareholders, the ability to award repurchased shares to employees as equity compensation, a modest tax advantage to shareholders (less pronounced since the 2003 dividend tax cut), and the ability to signal the company’s good prospects to the market. Finally, share repurchases represent well-disclosed and regulated arm’s length transactions at current market prices between willing participants.

Given the drive to regulate share repurchases, we would expect evidence of their drawbacks to be observable in public data. To test this, we documented trends in repurchases and compared trading volume, share price performance, CEO pay, and corporate financial activities (evidenced by investment and profitability) of companies that do and do not repurchase shares. We segmented the businesses that repurchased shares in two ways: (1) small positive versus large positive repurchase amounts (defined as below versus above median values), and (2) frequent versus infrequent repurchasers (defined as companies that repurchase in one or two quarters as opposed to three or four quarters of the year).

Our large-sample evidence on thousands of U.S. exchange-listed companies over the past three decades shows that repurchases in the U.S. are a mainstream corporate financial activity that returns several hundred billion dollars of capital to shareholders annually. At an aggregate level, we found that this activity neither creates nor destroys much wealth (that is, it does not produce significant changes in share price). In addition, while repurchases are associated with higher past profitability, they are not associated with excessive CEO pay or underinvestment.

Trends in aggregate repurchasing activity over time indicate that while repurchases have quickly grown in value, much of the growth can be attributed to inflation and increases in market capitalization. In addition, repurchases are now similar in size to dividends and have not grown faster than dividends for quite some time. However, unlike dividends, repurchases drop precipitously (and temporarily) in times of corporate stress, indicating that they do in fact provide companies with the aforementioned benefit of payout flexibility.

A Closer Look at the Data

Through our analysis, we were able to systematically address each of the stated criticisms of stock buybacks.

First, do companies use share repurchases to manipulate the market by creating excess demand to drive up stock prices? If they do, companies that repurchase shares should have higher trading volumes than those that do not. But average trading volumes have largely remained quite similar for all listed companies, regardless of whether or how often they repurchase shares. In fact, in recent years, the trading volumes for companies that do not repurchase shares have greatly exceeded those of repurchasing companies, suggesting that any excess volume arising from repurchases is dwarfed by other forces.

If naive investors are tricked into buying shares of companies that engage in repurchasing behavior because of the resulting EPS inflation, we should observe short-term price bumps followed by poor long-term performance. However, regardless of whether or how intensely and frequently companies repurchased shares, we found no evidence that companies significantly outperformed in the quarters with repurchases. While we did find some marginal evidence that companies that intensely repurchase do outperform slightly in the quarter after repurchases, we found no evidence of future reversals in the short or long terms. This pattern of outperformance is more consistent with companies using repurchases to signal undervaluation — a benefit to investors — rather than to manipulate the market.

The second critique is that repurchases allow insiders to unfairly profit. If share repurchases as rent-seeking behavior by insiders were a common, systematic abuse, CEOs whose companies buy back shares would receive abnormally high pay, including salary, bonuses, and the value of equity awards. Using a model-generated measure of excess pay that has been vetted in earlier academic literature, we estimate that CEOs of companies that make large positive repurchases earn only $51,000 more than CEOs of companies that do not repurchase shares — a statistically and economically insignificant amount of excess pay. The difference is even smaller — $4,000 — when we compare CEOs of companies that repurchase frequently with those that do not repurchase. These differences are economically tiny in relation to the average CEO’s pay of several million dollars. Surprisingly, CEOs of companies that repurchase infrequently or repurchase small positive amounts earn the least excess pay, less than even the CEOs of non-repurchasing companies. None of this evidence suggests that companies use repurchases to boost CEO pay.

The third and final critique is that repurchases reduce companies’ ability to take advantage of investment opportunities, thereby sacrificing innovation and economic growth. We found that companies that do not repurchase shares invest more but are significantly less profitable than those that do repurchase shares. The companies that repurchase frequently and in large amounts are highly profitable and have steadily made investments in the past, and they continue to make large investments and, at the same time, return capital to shareholders. This suggests that profitable companies repurchase shares while maintaining a steady level of investment, whereas less profitable or loss-making companies do not (or maybe cannot) repurchase shares but are more investment-intensive in the hope of becoming profitable. While there might be isolated examples of poorly governed companies that choose to avoid profitable investments and instead return capital to willing shareholders, it is hard to see how directives encouraging or incentivizing such poorly run companies to retain cash would lead them to make good investments.

Potential stakeholders who may be affected by repurchase regulations include managers, other employees, shareholders, governments, and society at large. If a company is profitable, a CEO can pay excess cash out to shareholders in the form of buybacks or dividends, keep the money on their balance sheets, or invest in new projects. A small tax on share repurchases may not change corporate behavior significantly and might raise a small amount of revenue for the government. But if the tax rate grows high enough, companies will choose to not buy back shares and instead pay out exclusively via dividends or retain cash. In that case, the government raises no revenue but implements a de facto ban on share repurchases.

How a Buyback Ban Could Backfire

If a company were to switch to only paying out dividends, shareholders would lose the ability to choose whether to receive a cash payout and could face negative tax ramifications, given that dividends are taxed as income while capital gains are often taxed at a lower rate, and only when gains are realized. In addition, the company would lose important flexibility in difficult times, because cutting dividends is punished more by the market than cutting repurchases.

However, the move to restrict stock buybacks seems intended not to motivate companies to shift to paying back shareholders through dividends but to invest more in the business. There is evidence that retained cash is correlated with CEOs making value-destroying decisions, such as pursuing empire-building mergers, accruing personal expenses, or funding pet projects. It seems implausible that restrictions on share repurchases would induce CEOs of poorly governed companies to invest in value-enhancing projects that they otherwise would not have been funding.

From an employee standpoint, there is some evidence that labor unions are able to negotiate more successfully if their employers have excess cash, but there is plenty of evidence that constraints on a company’s flexibility to raise and distribute capital is bad for employees, especially during downturns. Empire-building mergers can also be bad for employees, given that M&As often result in the employees of the acquisition target being laid off and employees of the acquiring company being misallocated. In addition, some repurchased shares are reissued to employees, making any actions that are bad for shareholders also bad for stockholding employees.

Overall, our results show an absence of correlation between share repurchases and price manipulation, return reversals, excess CEO compensation, and underinvestment, which makes it highly implausible that economically significant causal effects of share repurchases still underlie the data. Corporations lose flexibility if they have to rely only on dividends, and evidence shows that poorly governed CEOs who retain cash often spend it on value-destroying mergers, expenses, or pet projects. It is implausible that policies designed to reduce repurchases will also reduce alleged but unobserved malpractices without imposing costs on U.S. public companies and other stakeholders.