Alternative motives for firms: Share buy-backs

The basic model of behaviour in the Theory of the Firm assumes companies are trying to maximise profits. Strong candidates can identify other motives under the surface too. These make interesting and effective evaluation points when explaining what firms might be up to.

The Economist describes as ‘sensible’ those firms that survived the 2007-08 crash by avoiding too much debt, keeping their costs under control and their eyes on long-term opportunities in emerging markets. This sounds like confirmation that the best companies are long term profit maximisers.

But in the era of weak growth and low interest rates that has come since then, those same firms have become fixated with the growing practice of share buy-backs.

According to the article, over the past 12 months American firms have bought more than $500 billion of their own shares, close to a record amount. IBM spends twice as much on share repurchases as on research and development. Exxon has spent over $200 billion buying back its shares, enough to buy its arch-rival BP. The phenomenon is less extreme in other countries, but even Japanese companies are getting hooked. Why?

When firms buy their own shares in the open market they return surplus cash to their remaining shareholders by pushing up share prices, rather than paying out dividends. And if firms can’t find opportunities for profitable investment, handing cash back to investors is the right thing to do. So in many ways the surge in buy-backs is a symptom of the rich world’s feeble growth prospects.

But the article also spots how this is probably at odds with long run profit maximisation. Buy-backs may well come at the expense of long-term investment projects. There is a clear evidence of the so-called principal agent problem at work here. By reducing the number of shares outstanding, buy-back schemes can also artificially boost a firm’s earnings per share. This helps explain why managers whose pay depends on reaching specific earnings-per-share targets like to buy back shares.

Many firms finance buy-backs out of profits, which is fair enough. But in 2013, 38% of firms paid more in buy-backs than their cashflows could support, an unsustainable position. Instead, they are borrowing heavily to pay for buy-backs. If firms are overdoing buy-backs and starving themselves of investment, artificially propped-up share prices will eventually tumble.