This post is by Jeff Carter from Points and Figures
Click here to view on the original site: Original Post
Bernie Sanders and Chuck Schumer want to restrict stock buybacks from corporations. I empathize with them. Here is why.
I really believe that investors ought to be able to make decisions with their own money. I feel like dividends are an essential part of owning a public company and investors have the first right to those cash flows. It’s part of the reward for taking the risk of investing in common stock and holding the worst possible position on the balance sheet. Of course, stock appreciation is a part of it too and common stock appreciation can yield a big windfall.
However, tax policy makes passing along dividends cost prohibitive. We tax corporate profits. At least in the Trump tax plan, corporate taxes dropped but the most efficient tax scheme would be a 0% tax on corporate profits since corporations only aggregate taxes and pass the cost along to their .
After the money gets taxed at the corporate level, it gets taxed again at the dividend level if a distribution is made.
Government double dips on investor profits.
Buybacks aren’t taxed.
If you look at corporate finance theory, there is virtually zero difference in economic outcome between a dividend or a buyback. Zero.
Yes, that fact sticks in my craw a bit since I prefer dividends and as a long term holder of the stock would rather decide what to do with the money myself but there is ZERO difference for the economy if the corporate buys stock that people sell back, using those proceeds to do what they want…or they issue me a dividend.
Bernie and Chuck’s idea is stupid because they aren’t changing the tax code at all to marry the policy they want. It’s also stupid when you think about corporate finance theory.
But wait, there is more.
If a company builds up a massive amount of cash on its balance sheet it becomes a takeover target. Companies can buy other companies and use the cash sitting on the target company’s balance sheet as a part of the deal. It’s the CFO’s job to make sure they have the “Goldilocks cash” amount. The right amount for the company to cover it’s liabilities, expand and grow, and not so much that a corporate raider licks his chops.
Companies don’t like to manage for the short term despite what you read in the news. Their incentive is to stay in business as long as they can. Remember, 95% of the Fortune 500 from 1955 doesn’t exist anymore so staying in business is not an easy thing to do.
Here is an edited true story that might give you pause when you think about Bernie and Chuck’s policy.
Widget Company made widgets. They were in the widget business, a highly cyclical commodity business. They were flush with cash after a couple of years of high widget prices and their pension funds were very over funded. They were concerned that some financial raiders were going to make a move on their stock. So, the CEO decided that they should borrow a billion dollars (literally a billion) and pay a $50/share dividend. Widget Company’s stock price at the time was a little over $100 per share and after the announcement they dropped to about $50. (Nothing nefarious here, this fits in line with all corporate finance theory)
Remember, the company also gets to write off the interest against their tax bill from exposing themselves to debt. There are more moving parts to this than it seems on the surface.
The company went from having a strong balance sheet to being very highly leveraged. Some shareholders might have been happy. They had another $50 per share to invest someplace else. Of course, somebody who spent $100 of money already taxed to but a share and then got back $50 of it on which he had to pay taxes again, might not be so happy.
The company succeeded in scaring off any corporate cowboy that was trying to buy them out.
But in the next two years the widget market tanked and their profitability was zip. Long range planning became trying to find a way to make the next quarter’s interest payment so they didn’t default. They had to go out looking for a white knight and found one in White Knight LLC.
Why do Bernie and Chuck want to enable corporate raiders?