In his blog, Musing on Markets, my colleague, Aswath Damodaran makes an important point about the buyback controversy that reflects an even more important issue.[1]  First, with regard to buybacks, Damodaran notes that the financial theory is simple.  Companies whose objective is to maximize value should undertake all projects for which their value exceeds the cost of investment.  Because value is a function of expected cash flows over the life of the investment, companies following this rule automatically have the appropriate long-term viewpoint.  If there is free cash flow left over after making value enhancing investments, finance theory teaches it should be returned to investors as dividends or buybacks.

Lurking behind this first issue is the second, more important, one: how do top executives really behave?  Are they really taking a long-term view and attempting to maximize shareholder value or are other incentives, such as personal gain, the driving force?  For instance, Heaton (2018) describes how repurchases can benefit shareholders, at the expense of bondholders and other debtors.  Even more negatively, some critics claim that companies try to do whatever they can to generate more cash for buybacks, including holding down worker wages, turning away good investments, and taking on unwise debt.  This suspicion of corporate behavior is a growing problem that has implications far beyond share buybacks.

Back in 1987, Alan Shapiro and I argued that what we called organizational capital, and what is now more generally referred to as social capital, was an important element of value creation at companies. [2]  As described by, Sapeinza and Zingales (2011) social capital is features of social life – networks, norms, trust, that enable participants of a given community to act together to pursue shared objectives. [3]  In the corporate world, those shared objectives are the effective and fair management of a company that leads to the maximization of its long-term value.

Berkshire Hathaway is a good example.  There is little doubt the Mr. Buffett and Mr. Munger, along with Berkshire’s board, do their best to create shareholder value at the company.  It helps, in that regard, that Mr. Buffett and Mr. Munger take salaries of only $100,000 – admittedly a ridiculously low number.  As a result, there was little hand wringing when Mr. Buffett announced the terms under which Berkshire would repurchase shares or when the company actually repurchased shares.  Members of the Berkshire community were confident that Mr. Buffett was acting in the best interest of the company.

Social capital, and the associated trust, are valuable corporate assets.  Like other corporate assets, if not properly maintained they depreciate.  It is here that executive compensation enters the picture.  Exhibit 1 presents data on the ratio of CEO compensation compared to that of private-sector, non-supervisory, workers.  Between 1965 and 2018, the ratio rose from 18 to over 300.  While some of that increase can be explained as the result of changing economic conditions, the movement is so large that it impinges on trust and thereby depreciates a company’s social capital.

The point here is that the debate about buybacks is not really about share repurchases, it is about social capital and trust.  It is a question of whether top executives and boards are acting in the interest of the company and its stakeholders or in their own interest.  As such, the buyback debate foreshadows future battles over issues such as corporate tax rates, special corporate subsidies, the composition of boards of directors, and, of course, executive compensation.  There is a significant risk that those battles will further erode social capital and trust.  To the extent that occurs, everybody loses.

CEO-to-worker compensation ratio: 1965 to 2018
Year Ratio Year Ratio
1965 18.4 2010 206
1973 20.5 2011 213
1978 27.4 2012 210
1989 53.7 2013 214
1995 136 2014 224
2000 411 2015 225
2007 240 2016 250
2009 184 2017 271
2018 312

 

 

[1] Aswath Damodaran, https://aswathdamodaran.blogspot.com/2019/02/january-2019-data-update-8-dividends.html.

 

[2] Bradford Cornell and Alan C. Shapiro, 1987, Corporate Stakeholders and Corporate Finance, Financial Management, 16, 5-14.

 

[3] Palo Sapeinza and Luigi Zingales, 2011, Trust and Finance, NBER Reporter, 16-19.

 

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