For a great example of what I’ve been talking about, check out this Dealbreaker post on how Netflix spent the past two years buying back its own stock, and then just this past Monday turned around and announced that it was selling stock again. Matt Levine:
NFLX bought 3.5 million shares of stock at an average price of $117 in 2010-2011, at a total cost of $410 million, and paid for it by issuing 5.2 million shares of stock at an average price of $77 in November 2011, for total proceeds of $400 million – minus $3 million that we pay to Morgan Stanley and JPMorgan to place the deal. So 1.7 million extra shares outstanding for net proceeds of negative $13mm or so.
The comical thing about this from the point of view of the financial press is the buy-high, sell-low side of it. And of course whoever was on the other side of Netflix’s share repurchases this past summer, when the stock was at four times its current value, must be laughing right now. But as Levine says, this is what the system is set up to do:
Most companies are rewarded for squeezing every last penny out of EPS [earnings per share] – in executive bonuses, sure, but also in stock price more broadly. It’s what investors want. … So with Netflix: when things are good and it’s rolling in cash, it pushes up its price by buying. When things are bad and it needs cash, it pushes down its price by selling. And its incentives are neatly aligned to do so: when things are good, it needs one more penny of EPS; when things are terrible – hell, who cares about dilution when you’re unprofitable anyway? (It’s a good thing!)
Another way of looking at this, tho, is that buying its own shares high and selling them low is exactly how a firm should behave if shareholders really are the residual claimants, operationally and not just in principle. In the textbook this doesn’t really come out, since “shareholder as residual claimant” is just a first-order condition imposed on some linear equations. But if you take it seriously as a claim that shareholders own every incremental dollar that the firm earns or raises, and that management is a not just the solution to an Euler equation but a distinct group of people who may have their own views on the interests of the firm, then shareholders should want businesses to behave just like Netflix — pay out more when more is coming in, and then ask them for some back when more needs to go out. Can’t be a residual claimant if you don’t claim your residuals.
Now, financing investment is going to be more costly when it involves selling and repurchasing shares, compared to if you’d just kept the savings-investment nexus inside the firm in the first place. And these transactions were also disastrous for the firm’s long-term shareholders — in effect, they transferred $400 million from people who continued holding the stock to those who sold in 2010 and 2011. So in this case, a system designed to maximize shareholder value didn’t even deliver that. Shareholders would have done better with management who said, Screw the shareholders, we’re going to build the best, biggest online movie rental company we can. If you own our stock just sit back, shut up, and trust that you’ll get your payoff eventually.
As the man says, “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”