U.S. corporations hold more than $2 trillion of cash from historical earnings offshore. They may be encouraged to repatriate much of that cash based on evolving tax proposals from the Trump administration and congressional Republicans. While it is unclear what, if any, restrictions would apply, companies may be tempted to increase — and some investors will call for — share repurchases. According to a 2016 Goldman Sachs research report, S&P 500 share repurchases could rise 30% in 2017, to $780 billion. But are repurchases the optimal use of capital?
Past experience sheds doubt on whether reducing tax rates on repatriated cash would have the intended effects of increasing capital investment and job creation. In 2004, Congress passed the Homeland Investment Act (HIA), which provided a one-time tax break for repatriating foreign cash by U.S. corporations. Certain studies, including “Watch What I Do, Not What I Say: The Unintended Consequences of the Homeland Investment Act,” by Dhammika Dharmapala, C. Fritz Foley, and Kristin J. Forbes, have shown that a significant portion of the repatriated cash at that time was used to fuel incremental share repurchases rather than growth investments.
However, our question is not for government policy-makers but for corporate executives: Given the current conditions, why not consider reinvesting this cash in capital expenditures, research & development, and acquisitions rather than repurchasing shares?
The investor Warren Buffett has said that a company should repurchase shares when (a) the share price is well below intrinsic value and (b) cash held is in excess of operational and liquidity needs. Repurchasing shares at a premium to intrinsic value or when higher return investments are available destroys shareholder value; conversely, repurchasing shares when the price is at a discount to intrinsic value creates shareholder value by generating favorable returns on capital relative to alternative investments.
Companies cite a host of reasons for repurchasing shares, but often fail to verify that their shares are trading at a discount to intrinsic value, and to sufficiently consider investment alternatives given dynamic market conditions.
Companies repurchase shares to manage earnings per share, limit dilution from stock-based compensation, return capital to shareholders tax-efficiently, and alter capital structure. Low interest rates and pressure from activist investors have also been major drivers of repurchases recently.
While improvements in business fundamentals (e.g., revenue and margin growth) drive EPS growth and create shareholder value, the relationship between share repurchases and total shareholder return is weak. Further, leading analysts and investors have raised concerns about whether companies are too focused on short-term EPS performance. Repurchasing shares to boost EPS in the short term can hurt long-term growth prospects and investor returns. The same Goldman Sachs report said that during 2016 S&P 500 companies with the highest capital expenditures and R&D spending returned 18%, while those with the highest shareholder payouts, including share repurchases and dividends, returned only 8%.
Senior management and boards frequently justify share repurchases by suggesting that they can offset the dilutive effects of stock-based compensation. However, not only is stock-based compensation a very real expense to shareholders, but if companies repurchase at a premium to intrinsic value, they exacerbate the negative effects on shareholder value.
Before earmarking what could be substantial repatriated cash for more share repurchases, CFOs should regularly lead a systematic and objective process to, first, assess whether share price is below intrinsic value. Empirical data shows that companies tend to increase repurchases when their share prices are trading at cyclical highs (which is also when cash tends to be most plentiful). While there are practical challenges in doing so, companies should perform a robust, objective valuation analysis using conservative assumptions to determine whether buying their stock will create or destroy shareholder value. Especially with the stock market near all-time highs, CFOs should scrutinize whether repurchasing is a prudent investment.
Second, CFOs should be constantly evaluating repurchases in light of current conditions. Many factors in the market today point to a lower allocation for share repurchases:
- Operating and liquidity needs. Heightened geopolitical and economic uncertainty should encourage CFOs to scenario plan and stress-test assumptions, in order to identify what can reasonably be considered excess cash.
- Regulatory environment. The Trump administration is expected to pare back existing regulations while Congress has begun the process of repealing and replacing the Affordable Care Act. There will likely be new, long-term organic and inorganic investment opportunities for many companies.
- Fiscal and trade policy. Lower corporate taxes would mean additional cash for companies to reinvest or return to shareholders. If “border adjustment” taxes were to become policy, companies would need to consider investments that shift their value chain toward the U.S. The Trump administration has also advocated for significant infrastructure spending, which could provide investment opportunities for many companies.
- Monetary policy. Relatively low interest rates have been a key driver of recent share repurchases, particularly those funded by borrowing. However, the Federal Reserve raised rates at the end of 2016 and has indicated that future hikes are likely in 2017.
- Technological disruption. Technological forces threaten to undermine existing products, services, and business models across virtually every sector. Companies should confront potential disruption by evaluating the capital investments, R&D, and acquisitions needed to remain competitive.
There is a role for share repurchases in a balanced capital allocation strategy under the right conditions (shares trading at a discount to intrinsic value, excess cash available, and alternative investment opportunities that are not compelling). If companies determine that the optimal use of capital is to return it to shareholders but the share price exceeds intrinsic value, then a special, one-time dividend may be the appropriate alternative.
CFOs should ensure that senior management and the board are aligned on capital allocation priorities. Companies can develop credibility with investors — from institutions to activists — by clearly articulating the rationale for capital allocation decisions and delivering business results that demonstrate they are optimizing capital given current conditions.
Jeffrey Greene is the EY global life sciences leader for transaction advisory services and leads the EY Corporate Development Leadership Network (CDLN). Daniel Burkly is a senior manager in the transaction advisory services practice of Ernst & Young LLP and a CDLN contributor.
The views expressed herein are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or the global EY network.