When corporate officers exercise their stock options, they cause a dilution of earnings per share. A share buyback strategy counters that dilution. Let me explain how.
Stock options are not allocated on shares of stock available on the open market prior to their exercise. As a rule, grantees of stock options exercise their options when the stock price is substantially higher than the strike price they were offered. Let’s say stock options were granted with a strike (or STOCKOPTIONS: THEWARBETWEENMANAGEMENT ANDSHAREHOLDERS 111
exercise) price $16 and the current stock price is $25. The grantee exercises to realize the $9 trapped profit, meaning that he or she purchases the stock from the company for the $16 strike price.
The company does notacquire shares on the open market to meet this demand; instead, it uses its standing authority to issue new stock (assum- ing that shareholders have previously granted this authority). Thus the option is exercised on newshares specially issued for the occasion. Does this matter to the average investor? Absolutely. This creation of shares for the sole purpose of meeting the requirements of stock options dilutes earn- ings per share (EPS) because it adds shares to the existing equity pool. (The same pie henceforth will be divided into more pieces; therefore, your exist- ing piece is necessarily worth less.) Recent studies suggest that dilution due to outstanding stock options may lower the value of a stock by between 2 and 4 percent.
How does reducing EPS hurt the average investor? Not necessarily in the way you might think—that is, by reducing the dividend stream. As we have already seen, there is almost no dividend stream to be reduced in the case of many contemporary corporations. No, the real impact is indirect. A majority of investors make their decision to buy on the basis of the EPS ratio. A lower ratio is likely to mean a reduced pool of potential buyers and an enlarged pool of potential sellers. This shifts the power balance between buyers and sellers in favor of sellers, which results in lower prices and there- fore diminishes the likelihood of capital gains. The same device that is sup- posed to lead to capital gains therefore can serve as a drag on those gains.
When the stock price rises, a stock-option plan tends to create a rising number of outstanding shares. (People cash in.) One way to counter this negative effect is by retiring an equal quantity of outstanding stock through other means. One such method is through channeling earnings to stock repurchase, either from the open market or through alternative methods such as a Dutch auction or fixed-price tender offers (although these have become less popular in recent years). Stock buybacks, in other words, can be used in conjunction with an executive stock option plan as a way for compen- sating for dilution as it occurs. Microsoft and Dell are among the firms that have a systematic policy of doing so.
Share buybacks also can be used as a stand-alone method for raising earnings per share, benefiting shareholders who are counting on capital gains. Of course, this particular use for earnings needs to be assessed com- pared with alternative uses. In their challenging Expectations Investing:
Reading Stock Prices for Better Returns, Alfred Rappaport and Michael
Mauboussin emphasize that stock repurchase does not automatically raise earnings per share. It all depends on the current price of the stock: For a share buyback plan to be effective, the stock needs to be undervalued within the corporation’s global financial context. As an illustration, Rappaport and Mauboussin show that in each particular configuration of a company’s cir- cumstances, there is a stock price beyond which share buyback actually low- ersthe EPS ratio.18
The same authors stress that in the case of an undervalued share price, stock buyback is an effective method for passing earnings back to share- holders—and more specifically, for transmitting value from sellers of the stock to its current owners: “One of the surest ways for a company’s man- agers to create value for its continuing shareholders is to repurchase stock from shareholders who do not accept management’s more optimistic view.
. . . Then wealth transfers from exiting shareholders to continuing share- holders.”19
Another benefit of share buyback lies in the tax perspective: “[A] tax advantage to buybacks is deferral. Shareholders can choose to retain rather than tender their stock and defer tax payments until they sell. Thus buy- backs are more advantageous than dividends not only because of the lower tax rate, but also because of the discretionary timingfor incurring the tax liability.”20
Michael Perry, IndyMac Bank’s CEO, considers that, contrary to habit, share buyback should not be driven by stock price but should instead reflect a company’s current economic circumstances. If a corporation’s activity sec- tor is cyclic—as is the mortgage industry—share repurchase should be used to expand or contract global equity, reflecting what part of the cy cle the company is currently in.
In March 2002, Allan Greenspan commented on share repurchase plans:
Prior to the past several decades, earnings forecasts were not nearly so important a factor in assessing the value of corporations. In fact, I do not recall price-to-earnings ratios as a prominent statistic in the 1950s. Instead, investors tended to value stocks on the basis of their dividend yields. Since the early 1980s, however, corporations increasingly have been paying out cash to shareholders in the form of share repurchases rather than divi- dends. The marginal individual tax rate on dividends, with rare exceptions, has always been higher than the marginal tax rate on capital gains that repurchases create by raising per share earnings through share reduction.
But, until the early 1980s, share repurchases were frowned upon by the Securities and Exchange Commission, and companies that repurchased STOCKOPTIONS: THEWARBETWEENMANAGEMENT ANDSHAREHOLDERS 113
shares took the risk of being investigated for price manipulation. In 1982, the SEC gave companies a safe harbor to conduct share repurchases with- out risk of investigation. This action prompted a marked shift toward repurchases in lieu of dividends to avail shareholders of a lower tax rate on their cash receipts. More recently, a desire to manage shareholder dilu- tion from the rising incidence of employee stock options has also spurred repurchases.”21
In other words, share repurchase plans are not (usually) blatant attempts at stock price manipulation. Instead, they are merely another reflection of the preferential tax treatment enjoyed by capital gains over dividends.