A lot of attention has been focused lately on stock buybacks. Specifically, they have been demonized as a way where shareholders get rewarded instead of the money going to employees or being taken by the government to dole out in welfare projects. What exactly is a stock buyback, how does it work, why are they done, and why should the money be used this way? Today we’ll answer all of these questions.
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Understanding how the free enterprise optimizes everything
The free enterprise system is truly an amazing thing. As long as there is enough competition and there aren’t artificial constraints imposed, the system will result in everyone getting the best (and the worst) deal that they can. Workers will be paid the maximum that they can for what they do while the employer will pay the minimum that they can. In the end, everyone gets what is fair. Consumers also get products at the lowest reasonable price and there is ample extra production that can be given away to charity.
The reason is that there is competition for both workers and jobs. To see this, picture a worker, Samantha. Samantha is a hair stylist and is fairly talented. As a result, she can get paid better than other stylists who are less talented. She could simply work for herself and do hair at people’s houses, but she has found that she can get more business, not spend her time worrying about taxes and complying with regulations, and make more money for her time if she works for others. She therefore chooses to work at a salon. She maximizes her pay because there are several salons that want her, so she is able to move around whenever she feels underpaid to one that pays more. In the end, she keeps about 90% of what she produces for the salon after their expenses.
The salons obviously want to pay the minimum they can, but they need to have workers to bring in income. They need to pay for rent, utilities, keeping the books and complying with regulations, and advertising. Because there are other salons, they need to pay enough to stylists like Samantha to get them to work there, but they need to pay for their expenses. They also need to make enough to make it worth their time to do all of the work needed to keep the salon going. They therefore will raise their pay to stylists, especially if they are good, but only to the limit where they are making enough to make it worth their time. Beyond that, it is not worth it to get Samantha to work there regardless of how good she is. They therefore raise their salaries to gain good employees, but only to the level where it is just worth it to hire people. This gives the employees the maximum possible salary.
Of course, there are also the customers. They want to pay as little as they can for a stylists who is good enough for their tastes. They may pay more for someone like Samantha, allowing the salons to charge more for her and for her to make a higher salary. There is a limit, however, where if a salon tries to charge too much for Samantha the customer will decide it isn’t worth it. They will either settle for a less talented stylist who charges less or go to another salon who is willing to take less for a stylist of equal talent. This raises the amount the stylist receives to the maximum they can, sets it at the minimum profit the owner is willing to accept, and gives the customer the best price they can get. Everything is optimized! This is the beauty of free enterprise.
Note that no one sits down and figures out optimal prices. They are adjusted through trial and error in the marketplace. Employees haggle for salaries and move around to find the best deal, owners hire and offer salaries until they find enough workers of suitable talent, and customers look around for stylists they like at prices that they can pay and which seem worth the price.
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Stock buybacks
In the case of publicly traded companies, the owners are now shareholders. They let the company use their money to buy things for and operate the business in exchange for a share of the profits, if there are any. The shareholders are taking a risk since if the company doesn’t make any profits and grow in value, they will never get anything in return for their investment. If the company goes bankrupt, they can lose their entire investment.
This risk they are taking will make investors leery of investing unless they are likely to see a return and make money. Furthermore, investors who never see a return from the company will eventually sell their shares and move elsewhere. If enough people want to sell versus those interested in buying, the share price will drop. When this happens, it will be harder for the company to make subsequent sales of shares to raise more money for expansions and other activities, pay their executives and employees with stock and stock options, and do other activities that require a good share price. If share price drops enough, there will also be institutional investors and others who will not buy the stock, further depressing share price.
Companies provide a return to investors typically through two methods: 1. Paying out a dividend and 2. Performing a share buyback. In the first method, the company pays out cash directly. In the second, the company buys back shares on the open market and retires them, thereby causing fewer shares to be on the market and the percentage of the company represented by each share of stock still out there to be more.
For example, let’s say there are 200 shares of company XYZ and they are selling for $100 each. XYZ has a great year that generates a large profit. They decide to take some of the money and do a share buyback, buying up to 100 shares on the open market for a maximum of $100 per share. Let’s say that they succeed and purchase 100 shares. The company now has 100 shares issued. Before the stock buyback, each share was worth 0.50% of the company (100%/200 shares = 0.50% per share). Now each share is worth 1% of the company.
What happens to the price of the company shares? Well, maybe nothing. Yes, there are fewer shares, but the company also just spent a large amount of cash to buy the shares (100 shares x $100/share) = $10,000 in our example. This means that the company has $10,000 less in assets than they did, so while each share is worth more of the company, the company has less in assets.
But reducing the number of shares means that the earnings per share increases. This is true not only for current earnings, but future earnings. As a result, share price may increase, thereby returning money to shareholders who can then sell the shares at a higher price. Of course, just sending a dividend is a cleaner way to pay shareholders. Share buybacks, especially when the company is continuing to dole out free shares and stock options to employees and executives. Often share buybacks end up just closing the loop for these compensation packages that are more lavish than if cash were paid instead.
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What happens if the money is given to employees or taken in taxes instead?
As stated previously, everything in free enterprise is optimized. This includes placing the returns investors get from stocks to the lowest level they can be. For large stocks, this has ended up being around 10% historically, 7% after inflation. Stock investors will adjust the price of stocks until the return they get is enough to just justify their investment with the risks they are taking. If the amount that they receive for their investments decreases, the stock price will decline by an equal amount.
If the return drops to zero because all of the money is given to the employees or taken in taxes, share price will drop to zero. No one will buy shares in the future, meaning companies will not be able to get funding for starting up or expanding. This means these companies may not exist. Those that do will need to build organically, like a hotdog stand that becomes a small cafe that eventually becomes a larger restaurant. This means a lot less opportunity for employees. Many places would only hire family members since they can all be paid less (or not at all) as the business builds and gets to the point where they make a decent return, so there may npt be many jobs around.
If the money were taken for taxes, it would have the same effect. Businesses might also raise prices to cover taxes, so consumers would end up paying more. But if tax policy were such that whatever the business raised was confiscated, business investment would stop. There would be no reason to do so. This would mean job creation and the availability of products and services would both decline. This means more welfare would be needed but there would be substantially less money available for welfare. If the government just started printing money, people on welfare might have dollars to spend but nothing to buy since little would be produced.
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Conclusions
So, in conclusion, there is already an optimal distribution of money going to employees and investors. Both are making the maximum possible and the minimum they would be willing to accept, thanks to the free market system. Consumers are also getting the best prices for the products they want to buy. Tax revenues are also near a maximum, so as much money as can be had for social programs is already being collected. There is also ample production, making goods available for charity.
While you may wish to do so, you cannot artificially step in and try to redirect any of the money anywhere. If you do so, it would result in unattended results that would be detrimental to employees and consumers. Free enterprise works best when it is free. Government’s only role should be to encourage as much competition as possible.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
