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Aswath Damodaran: Do Buybacks Reduce Investment?

I previously discussed an interview given by Aswatch Damodaran, professer at New York University's Stern School of Business, in a Goldman Sachs (NYSE:GS) special report on buybacks, in which he talked about the history of the practice. I now want to turn to the question of whether buybacks reduce investment, and whether they are a net gain for the economy.

Where does the cash go?

In finance theory, companies should buy back their own shares if they are unable to generate an internal rate of return that is greater than the "hurdle rate" - what you could make by putting your money into something else. If a business is unable to beat that benchmark by reinvesting its capital, it should return it to shareholders.

One of the commonly cited criticisms of buybacks is they reduce business investment. This is, of course, true by definition. As Damodaran pointed out, however, that money goes elsewhere in the economy:

"Where did the $800 billion worth of cash used for buybacks in the U.S. last year go? That money didn't just disappear; shareholders typically use their returns to invest elsewhere in the market. So it's not that companies are investing less; it's that different companies are investing. And so the question is not whether you want companies to invest or to buy back shares, but rather which companies you want investing: the aging companies of the last century, or the newer companies that have better investment opportunities today? Choosing the latter should redirect cash from bad businesses to good businesses, boosting the economy in the long run."

He further argued that many of the companies buying back their shares are in the late stages of their life cycles, and that it is difficult for them to find ways to deploy capital efficiently. Damodaran does acknowledge that some companies do buy back stock for the wrong reasons - because of pressure from shareholders or because managers want to follow the crowd, but by and large he believes the practice is being used efficiently.

Of course, this perspective ignores the fact the glut of easy money that has flooded capital markets since quantitative easing started in 2010 has made it easier than ever for businesses to repurchase their own shares. When given the choice between trying to find productive uses for capital in their own companies (difficult) and reducing the number of shares outstanding (easy), it's not difficult to see why some managers opt for the latter way to juice their earnings per share. Reducing the number of shares is definitely easier than increasing earnings.

This isn't to say all companies do this. Far from it. But I believe there is a sufficient number of large companies with poor managerial incentive structures for it to be a problem. And ignoring this problem only makes the likelihood of populist backlash against the practice of buybacks more likely, the consequences of which Damodaran discusses later in the piece. We will return to this in the next part of the series.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.