One of finance theory's more outlandish notions is that public companies should be indifferent to the relative levels of debt and equity in their capital structure. Hence shrinking the equity base of the company, and its cash, should not matter. But the theory has been roundly debunked by the credit crunch. It is one of those ideas with a logical basis - to minimise the cost of capital - that doesn't survive contact with the real world.
Many large companies allocate surplus cash flow partly for cash dividends, partly for share repurchases, partly for acquisitions and partly for capital spending. Bank of England data for the four months to end-January 2012 shows share repurchases totalling £2.8bn - more than three times the value of share issues over the same period.
But why are share repurchases considered a legitimate use of cash flow? The original justification for them was the marked difference in the taxation of investment income and capital gains. But is it the job of corporate management to change distribution policy in such a way that favours one class of shareholders (higher-rate income tax payers) over another?
Shrinking a company's equity base through share repurchases inflates earnings per share (because there are fewer shares outstanding) and increases return on equity. All shareholders benefit in theory because their pro-rata stake in the company increases without any immediate tax consequences. In cash terms, however, the only shareholders who benefit are those who sell their shares into the repurchase programme.
Even if there is a temporary positive impact on the share price, which is all that most academic research suggests, any benefit to the mass of long-term shareholders is an illusion if the shares become riskier as a result. And, since share repurchases increase gearing, this is likely to be the case.
Good intentions?
This is one of those grey areas where what matters is the underlying intention. A small company buying in stock to eliminate a specific overhang of stock is one thing, for example, and may benefit all shareholders as a one-off. But systematic repurchases of stock year in year out are a different matter.
For one thing, if share repurchases are made when a stock is overvalued they destroy value for remaining shareholders as the company's share rating falls back to normal levels. Share repurchases to negate dilution from option grants and long-term incentive plans simply function as a transfer mechanism, moving value from outside shareholders to management (see below). And if a company's shares are undervalued, it is not the job of management to remove that anomaly and deprive perceptive investors of the opportunity to benefit from the value on offer.
Equally bogus is the idea that companies with a high return on equity are justified in mounting share buy-backs because shareholders would not be capable of replicating that return elsewhere in their portfolios. This is nothing short of patronising. The only real justification for either not paying or for holding down cash dividends to shareholders is if the company has viable and high-return investment projects that require capital investment but inadequate cash to pursue them.
Companies that simply hoard cash rather than paying out special cash dividends to shareholders should be viewed with suspicion. Hoarding cash that belongs to shareholders without distributing it to them is empire-building. It can seduce management into making bad decisions. Disasters can happen if a long-standing cash pile is used to make ill-judged or overpriced acquisitions to satisfy the ephemeral market fashion of the moment. Just ask the hapless former shareholders of Marconi (aka GEC).
Finally, beware of the argument that in mounting share buy-backs, a company is showing confidence by investing in itself. This is wholly specious. There is no real investment. A company is simply reducing its equity base and reducing its cash at the same time. That cash flows to one class of shareholders, those who sell at the time, rather than to all.
