Aswath Damodaran is a professor of finance at New York University's Stern School of Business, where he teaches corporate finance and valuation. He recently gave an extended interview in a Goldman Sachs (NYSE:GS) special report entitled "Buyback Realities." I have written previously on the subject of buybacks, arguing the way they are currently implemented has inflated valuations across the board. While I do not think they should be banned, I do think there is a problem with how the practice is carried out in an environment of ultra-low interest rates.
Damodaran has a more positive view on buybacks, arguing that they allow capital to be reinvested elsewhere in the economy and, therefore, are on balance efficient. The interview is interesting, even though I don't necessarily agree with everything he has to say, and deserves some discussion.
The history of buybacks
When asked about why buybacks have become so popular over the last several decades, Damodaran said he is surprised it took this long for the idea to catch on. He thinks the reasons are historical:
"If you look at history, part of the reason companies started paying dividends was because bonds predated stocks. So when stocks were first listed, the only way you could get investors to buy them was to dress them up like bonds with a fixed dividend basically mimicking a coupon."
So dividends were originally a marketing tactic. What Damodaran says makes a lot of sense. If you read Graham and Dodd's "Security Analysis," one of the things that really stands out is their strong preference for bonds over equities. To them, investing in stocks was almost closer to speculation than actual investing, as holders of common stock have no guarantee of returns, at least not in the same way debtholders do.
The reasons for this are multifaceted, but one important factor was that regulations around disclosure were a lot looser back in the day, and fraud was much more widespread. Therefore, investors did not have a lot of confidence in the cash flows reported by companies.
Damodaran went on to say that dividends aren't really a good fit for companies:
"But dividends have never made sense as an equity cash flow. The essence of buying stock in a company is laying claim to whatever receivable cash flow is not otherwise being used. That means it should be different every year. But dividends historically are sticky. Buybacks, on the other hand,can be thought of as flexible dividends that allow companies to return more cash in years when they have more cash, and less or none at all when they don't."
A clear advantage of using buybacks over dividends is that dividends can lock management into commitments they are unable to honour. Forecasting cash flows and earnings is a lot more difficult than the money management industry would have you believe (which, incidentally, is why Warren Buffett (Trades, Portfolio) does not ask for earnings estimates from his Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) subsidiaries). Cutting a dividend is considered a serious black mark for a company. Consequently, management will often not cut their payout, even when it would make long-term financial sense to do so. Buybacks are, by nature, fluid and subject to change (and, more importantly, shareholders understand and accept that they can change).
Damodaran concludes his response by pointing out the earnings of the big companies of today are a lot less predictable than their counterparts 50 years ago due to globalization, increased competition and the rise of service-based (rather than product-based) tech companies. In this context, buybacks should be even more attractive to managers.
There is a lot more to unpack in this interview, so in part two of this series, I will be examining Damodaran's responses to some of the issues raised by critics of buybacks.
Disclosure: The author owns no stocks mentioned.
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