How share buybacks and cheap debt are used to boost stock prices
A lever long enough to move the market.
September 2, 2022

Share buybacks, which occur when a company repurchases its own stock, are the financial analogue to optical illusions. Depending on the way you look at them, buybacks can be a responsible method of returning cash to shareholders, an admission that a company has no profitable investments to pursue, or an accounting trick used to boost stock prices. Unlike optical illusions, though, the differing interpretations of buybacks are not merely the fault of our perception. Depending on the way buybacks are executed, they really can have differing impacts on share prices.

The struggle to understand the impact of share buybacks is rooted in the inherent strangeness of the transaction. Like the ouroboros eating its own tail, buybacks involve a company purchasing itself. Typically, buyback programs are conducted in the open market. A firm will purchase their stock on the exchange from willing buyers at the current market price. From this perspective, buybacks are just an alternative to dividends, as both are methods of paying out cash to shareholders. But while dividends create a taxable event for every owner, buybacks only create a taxable event for those who wish to sell.

The announcement of an increased buyback program, then, can lift share prices by signaling a growing company with responsible management. In the short-term, the increased market demand for shares caused by the buybacks may lift share prices even more. In the limit, though, buybacks financed with retained earnings must lower stock prices. Paying out profits to shareholders reduces the cash on the balance sheet, making a firm less valuable. Even if earnings per share have increased by lowering the amount of outstanding shares, earnings are just one component of the value of a company. It is this same logic that causes stock prices to drop when a stock goes ex-dividend.

If a firm finances its buybacks with debt, though, the situation can be quite different. Given that equities are a riskier investment than debt, investors typically require a higher rate of return from stocks than from bonds. Since the rate of return for an investor is the cost of capital for a company, a company can lower its costs by reducing the average rate of return it gives investors. One way to do this is by issuing debt to finance share buybacks. If a firm can issue 4% bonds to purchase shares from equity investors who would have required an 8% return, then expensive obligations have been paid off with relatively cheaper ones.

By taking on debt to concentrate the equity of a company among fewer owners, though, a firm also levers itself. As financial practitioners know, leverage increases the volatility of returns, both on the upside and the downside. This means that in buoyant economic environments, when earnings are strong, buybacks financed with cheap debt will boost stock prices, as there are fewer owners to share the rewards with. But if an economic slowdown occurs, there will also be fewer owners to share the losses with.

Criticisms of buybacks that focus on the manipulation of earnings per share are compelling, but ultimately misplaced. It is the leverage taken on by companies that boosts earnings per share without simultaneously draining the balance sheet. Quantitative easing by central banks, which attempts to lower long-term interest rates, has allowed companies to lock in rock-bottom financing costs for years to come. Corporate leverage, as measured by the ratio of corporate liabilities to gross domestic product, has marched ever higher since quantitative easing programs were launched after the 2008 crisis. Facilitating buybacks financed with cheap debt is one of the ways quantitative easing helps boost stock prices.

Ultimately, buybacks are so illusory because they are the wrong thing to look at. What truly matters is not that cash is being paid out, but how that cash is financed. Companies respond to incentives, and the cheap debt enabled by quantitative easing gave businesses the motivation and the means to lever themselves to boost share prices. But while the music is playing, it is easy to forget that leverage also magnifies the downside.

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