38
Repurchase Stock to Revitalize Equity

Share repurchase by large public corporations is now done in substantial volumes, but when this article appeared in The Harvard Business Review in 1965, most companies had never considered the idea. (Naturally, thrilled that the editors decided to publish such an unorthodox article, I was further delighted when Professor Alan Young proposed that we combine our efforts in the area to produce a book that Ronald Press agreed to publish and that opened the door for me to book writing.)

The real winner was Goldman Sachs and its trading desk. Purchasing a few hundred copies of my book, Share Repurchase, they sent the book to corporate Treasurers as validation of the share repurchase concept and offered to help. In days of 40¢ per share commissions, Goldman Sachs did brisk business in share repurchase, buying many millions of shares.

An important new development is becoming increasingly apparent in the annual reports of a growing number of major industrial corporations: preferred stock is being retired, debt capital is being used less and less and, as retained earnings and cash flow rise rapidly, senior capital is being replaced with equity. The result is an unprecedented equity capital abundance. Is this a generous blessing or a curse in disguise? It all depends on your point of view.

While a plush financial condition allows management to do what it wants when it wants, without financial constraints and limitations, plentiful liquid assets and/or limited debt usage usually mean an unnecessarily heavy reliance on stockholders' equity. The evidence may be visible—large nonoperating assets or invisible—unused debt capacity and redundant working capital. But in either case the result is a needless waste of the potential strength and vitality of the investors' capital. This waste creates a major new problem for the owners and their representatives, the board of directors.

Unless the trend toward increasing dependence on equity capital is reversed, the problem just described will become more acute. The present situation calls for new methods of approach and action; the trends toward the future demand a careful rethinking of that most basic of all corporate money matters, the capitalization of the enterprise.

In this article I shall assume that the principal objective of capital strategy, particularly the determination of the size and mix of capital, is to maximize the owners' long-term interests as measured by wealth (market value of shares) and income (dividends per share). I shall argue that to accomplish this objective, financial planners should give careful consideration to a flexible and potent, but often overlooked, procedure: buying back common stock.

Bolder Role Needed

If a corporation is unnecessarily dependent on equity capital, it can advance shareholders' interests significantly by what I like to call “reverse dilution,” or the concentration of equity by replacing unnecessary common shares with limited obligation capital, such as debt and preferred. This can be seen with simple arithmetic. Suppose a company with $20 million of earnings contracts the equity base from 10 million shares to 9 million. The effect is as follows (Table 38.1) (assuming income taxes at 50%, market value at 15 times earnings, and debt interest at 5% on the purchase cost of $30 million):

The arithmetic (where applicable) poses a most important, but seldom specified challenge to the corporation with excess equity capital: Can the board of directors justify a capital policy which tends to insulate management from the rigors of financial discipline and obliges stockholders to leave unnecessary amounts of equity capital tied up in the enterprise?

Stated as a challenge to present policy, the problem of redundant equity is not limited to shareholders and the directors who represent them, but extends to the management of the corporate entity, which would suffer a reduction in total net assets and income if equity were reduced and debt increased to develop reverse dilution. In a rapidly growing company, reverse dilution can be accomplished over a period of years by increasing the proportionate use of senior capital. But in most cases reverse dilution must be accomplished by both increasing the use of senior capital and actually reducing the amount of equity. The latter can only be done by repurchasing common shares.

Table 38.1 The Benefits of Repurchase

	Before	After
Earnings from operations ($)	40,000,000	40,000,000
Interest on debt ($)	0	750,000
Earnings before taxes ($)	40,000,000	39,250,000
Net income ($)	20,000,000	19,625,000
Outstanding common shares	10,000,000	9,000,000
Earnings per share ($)	2.00	2.18
Dividends (60% of earnings) ($)	1.20	1.31
Market value of 100 shares ($)	3,000	3,270

Present Practice

Although no large corporation has as yet fully accepted the broad role of share repurchasing to be proposed in this study, neither has the procedure been wholly ignored. More and more companies are utilizing the repurchase technique.¹ Usually, however, repurchase has been viewed only as a defensive device to avoid dilution. Various reasons are given to justify expenditures on a reacquisition of shares. For instance, it is argued that repurchase will:

Avoid diluting earnings per share when stock options are granted and exercised by management.
Supply shares for employee stock-purchase programs.
Obtain shares for common stock bonuses to employees.
Provide shares for stock dividends.
Avoid diluting earnings per share when convertible securities are changed into common stock.
Increase the per-share asset value of investment companies when shares sell at a discount in the market.
Eliminate small odd-lot holdings, which are inordinately costly to service.
Compensate for the dilution of earnings per share which is incurred in a merger through exchange of shares.
Provide the means to acquire other companies. (It is ironic that many companies are proud of their policy of making acquisitions only with cash, “to avoid equity dilution.” Yet, because of the federal tax on capital gains in a cash sale, sellers fare better with exchanges of stock than cash payments and will usually accept a proportionately lower purchase valuation when these taxes can be avoided. For example, assuming a 25% capital gains tax on a cash transaction, and assuming the stock alternative qualifies as nontaxable, $100 in stock may be worth $133 in cash to the seller. Consequently, the acquiring company's stockholders' equity would be far less “diluted” if payment were made in shares previously acquired for this purpose in the open market for only three-quarters of the money needed for a cash transaction.)

Repurchase programs which are undertaken for the foregoing reasons occasionally result in a sizable volume of trading. For instance, General Motors' repurchases in 1964 amounted to 1,136,457 shares—or 10.5% of the volume in this stock on the New York Stock Exchange. As a rule, however, such reacquisitions do not lead to significant changes in the number of outstanding shares because purchasing is done specifically for reissue. In a recent study, Barron's found only 100 companies (out of several thousand listed on the major stock exchanges) with more than nominal holdings of their own stock; even in this group most companies were found to hold less than 3% of their total stock and were simply anticipating employee stock options and other similar programs.² Although repurchasing is widely accepted for stock options and other minor uses, it is clearly not often used for substantial changes in the equity base.

Later in this article I hope to show that repurchasing should not be limited to the defensive role of avoiding dilution. I believe many managements should consider a more aggressive approach, using it as a step toward achieving a more rational corporate financial structure in which debt and preferred capital take the place of redundant equity funds. First, however, let us review the objections to repurchasing common stock.

Major Objections

There seem to be five main arguments against repurchase. To each of them there is, in my opinion, a good answer.

Management Defeatism?

For some, buying in common stock has an unfavorable connotation of defeatism and that any management not finding new ways to use surplus funds is inept and dull-witted. At present the suggestion that a company “invest in itself” often draws prompt criticism. The following statement is from the president of a medium-sized company with no debt and a portfolio of marketable securities equal to nearly 10% of the market value of the company's stock:

This attitude is not justified. Financial annals are replete with case histories of unsuccessful and unprofitable acquisitions and expansion programs. While some managements have avoided the pitfalls attendant to investing in or acquiring other companies, more and more annual reports show that millions of dollars of redundant cash and other liquid assets are being accumulated. It is doubtful that an effort to relinquish this corporate “padding” through repurchasing common stock can logically be considered “going soft” or defeatism.

Sign of Deterioration?

An unfavorable aura somehow surrounds repurchase of common stock in the writings of financial classicists. These writers generally recommend repurchase only as a means of gradually liquidating a deteriorating company or one with wasting assets—and then only when the total market valuation of the common stock is less than current assets.

In fairness to these traditionalists, the corporate laws of this country appear to be unique among the major capitalist nations in permitting corporations to reacquire their own shares. English law takes the delightful but archaic position that the repurchase of common stock is a constructive fraud against creditors. Canadian law is more moderate but still prohibits repurchase of stocks as an unauthorized reduction of capital.

Needless to say, it is facts, not legends, that we are interested in. The facts, I hope to demonstrate, favor repurchase.

Debt Taboo?

There seems to exist a general management preference for equity and retained earnings rather than debt and preferred capital. For instance, after refinancing a large preferred issue with debt, a large metals company reported with apparent satisfaction that it still had one of the lowest debt ratios in its industry. And executives of other companies advertise that their organizations have practically no debt. This antidebt policy apparently arises from the exercise of personal preference by financial managers. There are good reasons to believe that it often conflicts with the interests of stockholders.³

Abuse of Power?

In recent years there have been some abuses of the power of American corporations to repurchase common shares. To illustrate:

One company bought out a single large stockholder without making a general tender offer, which would have allowed other shareholders to reduce or liquidate their holdings.
Another company sought to increase the marketability of a large shareholder's secondary offering at the then prevailing market price by using $1 million of company funds to buy a rather large portion of the about-to-be-offered stock for the corporate treasury. This move significantly reduced the number of outstanding shares, increased earnings per share, and lowered the price-earnings ratio to a level more in line with the capitalization rates of similar publicly held companies.
Another firm incurred stockholder dismay and anger by acquiring shares on the open market, management's motive apparently being to maintain control over the firm for a particular group of stockholders.

Obviously, repurchases can be inappropriate and can discriminate unfairly among common shareholders. But such abuses can easily be avoided by corporations willing to make full disclosure of their plans so that all stockholders are treated equitably.

Unfair to Stockholders?

Finally, some have argued when a corporation repurchases its own common stock, either the sellers or remaining holders may be hurt, and that management should not engage in any activity that tends to help some stockholders at the expense of others. Three points should be made clear:

A full disclosure of repurchase objectives enables shareholders to reappraise and act accordingly.
When substantial amounts of stock are to be reacquired, a tender offer will give all shareholders equitable treatment. Such a tender offer should be priced sufficiently above current market levels to balance (a) the advantages the higher present price to those who may wish to sell with (b) the advantages of higher future per-share earnings and equity values to those hold their shares.
When relatively small amounts of stock are to be purchased on the stock exchanges, a regular buying program both increases the active demand for and decreases the available supply of corporation's shares, and consequently tends to increase the price at which the shares will trade to the satisfaction of both holders and sellers.

Possible Alternatives

Thus the standard objections to repurchasing lose their forcefulness when considered carefully, and repurchasing should not be rejected out of hand. Are there, however, alternatives that management should consider?

Distributing Surplus

When current and anticipated cash inflows exceed present and expected internal cash requirements, an increase in dividend payout is usually appropriate. Such an increase may, however, be an inadequate solution to the problem of surplus cash flows.

Since managers and investors both expect a given level of dividends to be maintained, dividend payments are relatively inflexible; and most managements have been unwilling to commit themselves to a payout rate much above 65% to 70% of reported earnings. But since net funds inflows are typically appreciably higher than reported earnings, capital can accumulate rather rapidly, even with a relatively high dividend rate.

Moreover, increasing dividends above a normal payout level implicitly assumes that stockholders prefer more current income to an increasing share of equity in a prosperous and progressive enterprise with the prospect of even higher dividends in the future. This assumption ignores the tax advantages of investing the funds in the corporation through share repurchase.

While higher dividends probably are the most attractive method for distributing a moderately and consistently increasing surplus of cash flow, they are not appropriate when the surplus arises in a sporadic pattern of large amounts. In other cases, when retained earnings have accumulated over a number of years and have become a sizable equity surplus, higher annual dividends would seldom be an acceptable means to most managers of substantially reducing total equity capital.

Investment Expansion

Surplus funds may also be applied toward expansion or modernization, cash acquisitions or investments, and retirement of senior securities. As examples:

From 1956 to 1964, R. J. Reynolds Tobacco Company spent $160 million to expand and modernize facilities, increased working capital by $55 million, and reduced senior securities by $85 million. The total program more than doubled book values.
Consolidation Coal Company recently bought 7.7% of the common stock of Chrysler Corporation for more than $55 million, The market value of this investment has risen since then to over $170 million.

Table 38.2 Companies with Substantial Holdings of Short-Term Securities

Assets and debt in millions of dollars.

Nonoperating assets
	Nonoperating assets	As a percent of
	Assets ($)^*	Net assets	Value		Debt ($)
Eastman Kodak Company	310.3	33.8	5.6		—
Freeport Sulphur Company	39.2	18.1	11.5		—
International Nickel Company of Canada Ltd.	131.7	17.8	5.3		—
Libby-Owens-Ford Glass Company	121.7	43.5	16.5		—
Parke, Davis & Company	55.4	30.5	12.0		—
Phelps Dodge Corporation	145.4	15.2	20.5		—
General Motors Corporation	1,010.5	13.4	3.6		132.0
International Business Machines Corporation	724.0	31.4	5.0	3	70.4
Kennecott Copper Corporation	224.5	27.4	22.0		5.2
Minnesota Mining & Manufacturing Co.	57.9	10.2	2.0		8.5
Procter & Gamble Company	377.9	40.2	10.6		106.9

^* At year-end 1964, except for Procter & Gamble, whose assets are listed as of June 30, 1964.

While such investments have worked well for some companies, they often lack appeal for others. Modernization may not be called for. Expanding facilities and production may not be profitable if growth in market demand is limited. Cash acquisitions of attractive and compatible companies may be impracticable or prohibited by antitrust regulation. Investments in other corporations or marketable U.S. Treasury securities usually provide only a modest return on investment. Consequently, many firms find these methods of exploiting surplus capital neither satisfactory nor feasible. Moreover, these procedures may utilize only part of the redundant equity.

Because of the difficulties of profitably employing surplus capital in the company and/or distributing redundant equity funds to stockholders through dividends, a surprisingly large number of corporations have accumulated substantial holdings of marketable short-term securities to absorb redundant capital resources. The roster of such companies includes several having no long-term debt. Table 38.2 presents data for a few of these companies.

Reducing the Equity Base

Rather than accumulating liquid assets with only limited returns, financial managers may find that a better case can be made for repurchase- of a company's own common stock. For instance:

Following the transfer of its computer division to Bunker-Ramo Corporation, a joint venture with Martin-Marietta, TRW Inc. (formerly Thompson Ramo Wooldridge Inc.) received $17.4 million, approximately 8% of the total market value of its outstanding common stock. The company then made a tender offer for 250,000 of its common with an expected cost of $14 million. According to Chairman J. D. Wright: “The company now has funds in excess of its operating requirements for the foreseeable future. After considering various alternatives for the use of these funds, we have concluded that the purchase of additional shares of common stock would be more beneficial to shareholders from the standpoint of earnings improvement per share.”⁴

For many companies with existing or prospective holdings of low- and fixed-income securities, the repurchase alternative offers significant advantages to the common shareholder. But when managers or investors analyze the choice between expanding the company's operations and reducing its equity base, what standards should they use? I shall develop such a standard in the next section.

To begin, let us specify an ideal. A capital expenditure should:

Be of significant size.
Utilize the experience and skills of management without making undue demands on executive time and energy.
Use existing channels of distribution and serve familiar markets.
Require no substantially new technical or production skills.
Be based on highly reliable projections of future business developments.
Be limited to a specific capital expenditure.
Return significant profits quickly.

These “impossible” requirements can often be met, I believe, with repurchase of common shares. To demonstrate this, I shall describe a method of assaying the value of capital expenditures by comparing the benefit to the stockholders of increasing productive assets with the benefit of reducing the equity base. This appraisal index will be called the “stockholder standard.”

Deriving the Standard

Table 38.3 identifies the increase in per-share earnings which the management of a hypothetical company obtains by reducing the equity base by repurchasing common stock. It is assumed that $30 million is spent to buy 909,000 shares. For realism, the average cost of shares is assumed to be 110% of the prevailing market price. The gain in earnings per share for the present year (1965) is $0.20. To obtain an equal gain in earnings per share by spending the same $30 million on productive facilities would require an after-tax return of 6.7%. The calculation is made as follows:

StartFraction dollar-sign 0 period 2 0 times 1 0 comma 0 0 0 comma 0 0 0 s h a r e s Over dollar-sign 3 0 comma 0 0 0 comma 0 0 0 EndFraction equals 6 period 7 percent-sign

Obviously, if the $30 million were spent for new productive new facilities, they could not be expected to return profits in the first year; it is highly doubtful that the facilities could even be completed in the first year. Over a period of years, however, an investment in plant and equipment would presumably be profitable; so the entire future stream of profits must be considered. This is done by present-value analysis.

Present-value analysis should also be used to identify the comparable benefits of reducing the equity by repurchasing shares. Unfortunately, profits in the distant future are not susceptible to easy or accurate prediction, and management will wisely avoid making tenuous estimates. However, we can use a reasonable, simple, and more reliable shortcut by estimating the improvement in earnings per share for the fifth year hence (or fourth or sixth year, if management finds a different time period more appropriate), and consider this one year's increase to be equal to the total stream of all future earnings-per-share increases discounted to their present value.

In Table 38.3 the fifth-year gain in earnings per share is $0.25, or the equivalent of an 8.3% after-tax return ($0.25 times 10 million shares, divided by $30 million investment). Alternative investments can then be appraised by discounting their future after-tax returns by this investment-return figure. In effect, 8.3% becomes what is often called an “opportunity cost.” Its significance is this: if corporate funds spent on the repurchase of common stock return 8.3% after taxes, this is a more profitable outlay for shareholders than investments in productive facilities expected to yield a lower present-value return.

Table 38.3 Financial Effects of Buying Back Stock in a Hypothetical Case

Assumptions: 5% trend growth in earnings; market price is 15 times earnings; $30 million of available funds required to buy back 909,000 shares at 110% of market price.
	1965	1966	1967	1968	1969	1970
Earnings ($)	20,000,000	21,000,000	22,100,000	23,200,000	24,3000,000	25,500,000
Earnings per share:
With 10,000,000 shares	2.0	2.10	2.21	2.32	2.43	2.55
With 9,091,000 shares	2.20	2.31	2.44	2.56	2.68	2.80
Dividends (60% of earnings)	12,000,000	12,600,000	13,300,000	13,900,000	14,600,00	15,300,000
Dividends per share:
With 10,000,000 shares	1.20	1.26	1.33	1.39	1.48	1.53
With 9,091,000 shares	1.32	1.39	1.46	1.53	1.61	1.68
Increased produced by repurchase in:
Earnings per share	0.20	0.21	0.23	0.23	0.25	0.25
Dividends per share	0.12	0.13	0.13	0.14	0.15	0.15

Table 38.4 Stockholder Standards for Various Growth Rates

Price/earnings	Growth rate (%)	Stockholder standards
30	10	5
27	9	5
24	8	6
21	7	6.85
18	6	7.25
15	5	8.25
13	4	9.25
11	3	10
10	2	11

The increase in earnings per share is the stockholder standard by which investment opportunities can be judged from the shareholders' point of view. Projects which improve on the stockholder standard should be undertaken when feasible; others should be rejected unless qualitative factors override the mathematical evaluation. When managers deviate from the standard, they should do so explicitly and intentionally.

In Table 38.4 the stockholder standard is calculated for a variety of possible growth rates and price-earnings ratios. While these combinations of rates and ratios obviously do not cover all possible circumstances in industry, they do suggest the range in standards for varying situations. Each company should calculate its own stockholder standard using the price-earnings ratio of its own stock and its own expected growth rates.

Use and Significance

A policy of repurchasing stock guided by the stockholder standard has all the advantages of the perfect capital expenditure described previously, but it does have important drawbacks for some managers. Repurchasing common shares reduces corporate net assets as well as incoming earnings and cash flow. Moreover, the stockholder standard is not based on management's principal guide to investment decisions: cash flow. However, if comparing the stockholder standard to present-value cash flow seems like comparing apples and oranges, this incompatibility can be overcome by generating a standard that relates to cash flow rather than to earnings by substituting the expected increase in cash flow per share for earnings per share in the scheme shown in Table 38.3.

While the stockholder standard can be a useful guide to managers striving to sustain an efficient use of corporate capital for the long-term benefit of the owners, more powerful measures appear to be warranted before many corporations will be using equity capital efficiently. These are measures that will change the capital structure in a desired way, develop “reverse dilution,” and concentrate the power of equity capital by replacing redundant equity funds with fixed-cost capital. The next section will be focused on this question.

Rationalizing Capital

The most important use of common stock repurchases—and the most widely applicable—is the valuable flexibility provided to financial managers who are seeking ways to develop a rational capital structure which will meet the corporation's present and future requirements while optimizing the long-term wealth and income of the owners.

A rational capital structure may be described as one having the size and mix of capital that would be selected if the corporation were being fully recapitalized— if the slate were clean. Such a capital structure would have as its primary objective the long-range enhancement of stockholder wealth and income and would be based on the internal requirements of the firm after considering developments in the national or world economy, the industry with which the company is associated, and the markets to which it sells its goods and services.

The obvious and substantial differences in existing capital structures of large companies (see Table 38.5) are too great to be explained away as just differing opinions as to the optimum amount and composition of capital to enhance the stockholders' long-term interests while meeting the present and future requirements of the enterprise. Apparently, customs and traditions are going unchallenged. There seems to be too little awareness of the potentials of revised capital structures.

An example of a company that did see these potentials is Indian Head Mills: An unusual, but not unique, opportunity to exploit archaic capitalization was seen by the Indian Head Mills management. President James Robison was determined to create a rational capital structure in the equity-dependent textile industry and did so by substituting funded debt and preferred stock for the redundant equity capital in the firms he acquired. These were the exciting results: per-share earnings and dividends rose rapidly and with a higher price-earnings ratio, the market value of common equity zoomed ten-fold in less than four years!

Table 38.5 Variations in Debt-Equity Ratios in Various Industries

Industry	Company	(%)
Automobiles	American Motors)	0.0
	Chrysler	21.6
Chemicals	E. I.- du Pont de Nemours	0.0
	Air Products & Chemicals	48.0
Drugs	Parke, Davis	0.0
	Baxter Laboratories	48.0
Nonferrous Metals	International Nickel	0.0
	Cerro	15.0
Steel	Bethlehem Steel	8.8
	Wheeling Steel	32.1
Paper	International Paper	0.0
	Mead	23.0
Oil	Skelly Oil	0.1
	Sinclair Oil	29.0

The changes in capital that can be made by other companies in other industries may not be so dramatic, but nonetheless they can be eminently worthwhile. And effecting these changes does not require unwanted mergers.

Cost Analysis

How far is it profitable to go in buying back stock? Let us begin with a well-known concept in financial management. The traditional “weighted average” cost-of-capital analysis presupposes the existence of an optimum mix of debt, preferred stock, and common equity such that any change in the amount of one type of capital leads eventually to a proportionately equal change in all. This approach precludes the possibility that changing the capital mix can change the long-term cost of capital except in the special situation where the existing structure is substantially out of proportion to the optimum mix. In this “special” case, realigning the composition of capital can change the overall cost of capital.

The substantial decline in debt and preferred capital in recent years suggests that capital mix has been significantly skewed away from the optimum balance toward heavy equity usage, and that the special case in which rearranging the composition of capital will change the overall cost is actually becoming the general case today.

When a corporation has surplus equity capital, the true cost of this capital to the stockholders is the opportunity cost of not repurchasing common shares in the stockholder standard. A comparison of the stockholder standard to the cost of senior capital indicates the degree to which stockholder wealth and income can be advanced by reducing equity and increasing debt and preferred stock, that is, by moving the capital mix back toward the optimum through “reverse dilution.” The point to stop borrowing is when the difference between debt cost and the return on repurchase becomes narrow and/or the level of future debt charges seems unwise in view of anticipated cash flows.

As we have seen, when the stockholder standard exceeds the after-tax cost of debt and/or preferred stock, equity should be reduced while debt and/or preferred stock are increased. What may startle most readers is this: even at a very high price-earnings ratio, the stockholder standard can be significantly higher than the cost of either debt or preferred would be. (The situations portrayed in Table 38.3 illustrate this.) Thus, even in an extreme case, reducing equity by repurchasing shares may well improve the position of the common stockholder.

Finding the Optimum

Identifying the optimum capital structure involves two basic steps:

Identifying and comparing relevant costs for debt, preferred, and common stock.
Using these costs as guides in determining the most desirable capital mix and the corporation's financial requirements.

While the economics of repurchasing common stock make a good case for maximum use of debt and preferred stock, determination of that maximum can only be made by consideration of the debt capacity of the corporation. Therefore, a rational capitalization will be consistent with management requirements (with debt not in excess of corporate capacity and with stockholder objectives with equity not in excess of corporate needs).

A management anticipates future changes in the company and its business position, the optimum or “target” capital structure will change over time. Every shift in either the company or its surroundings offers the possibility that adaptive, responsive adjustments ought to be made in the total amount or the mix of existing capital. Consequently, a regular review which will identify changing financial needs and capacities must be integrated with a continuing program of adaptation to change.

Role of Repurchasing

Repurchasing provides valuable flexibility to managers striving to develop an optimum capital structure. The number of outstanding common shares can be reduced in several ways:

Tender offers—For example, American Radiator Company acquired over 10% of its common shares through a tender offer in 1963, using a prime rate bank loan of $20 million to provide the necessary funds.⁵
Block purchases—In late 1964, General Fireproofing Company purchased 121,558 shares (17%) of its own common from Rockwell-Standard Corporation following approval by a special stockholders' meeting.⁶
Regular purchases in the open market—Amerada Petroleum Corporation had acquired over 2 million (15.5%) of its shares by the end of 1964.⁷
Exchanging marketable securities—During 1964, Emhart Manufacturing Co. exchanged 27,621 shares of its holding in Monsanto Chemical Company for 39,800 of its common shares held by a mutual fund.⁸
Exchanging senior securities—Early in 1964, Ling-Temco-Vought, Inc. offered to exchange a combination of $7.5 million and 500,000 shares of convertible preferred stock for 1.5 million shares of common.⁹

As the foregoing suggests, financial managers have a variety of methods available to them so equity capital can be reduced considerably and conveniently. It should not be treated as a fixed or inflexible portion of the corporation's capital structure.

Market Reaction

Before embarking on a repurchase program, each management should consider carefully the impact that both the procedure and the objectives of repurchasing are likely to have on the price-earnings ratio of the company's common stock. Although executives may conclude from a brief consideration of repurchasing that the price-earnings ratio will decline if per-share earnings growth derives in part from reducing shares rather than wholly from increasingly profitable operations, it seems more likely that if investors and their professional advisers clearly understand the reasons behind a repurchase program, they will look favorably on reacquiring shares either to restructure capitalization or to provide effective discipline for capital expenditures. In fact, the higher rate of earnings-per share growth resulting from a reduction of the equity base may well increase the market valuation of the company's shares.

Since only knowledgeable investors can react intelligently, management should accept responsibility for educating stockholders as to the objectives of capital policy and should inform them regularly of both the practices the company follows and the results achieved.

Prior to implementing a repurchase program, management should seek the advice of legal counsel on such matters as state laws, corporate powers, authorization, and disclosure to the Securities and Exchange Commission and to the stock exchanges. Investment bankers can provide helpful advice to management regarding details of the actual buying program like daily volume limits, pricing, and selection of brokers for continuing open-market purchase programs, or regarding the appropriate terms and procedures for tender offers.

Conclusion

In recent years, substantial cash flows have altered the capitalization of many corporations and produced an uneconomically high proportion of equity capital. Consequently, reorganizing corporate capital to regain an optimum capital mix will often mean buying back common stock. This may lead to important improvements in shareholder wealth and income. The stockholder standard described in this article can be a useful guide to appraising capital costs and capital budgeting from the investor's point of view.

Retiring common stock is not as simple or routine as retiring debt and preferred; the acquiring company is dealing with its owners rather than creditors, and equitable treatment must replace the philosophy of caveat emptor. However, the problems are usually not nearly so great as are the potential advantages to the stockholders.

It is widely known that industrial corporations have been “out of the market” for new equity capital for several years because capital requirements have been increasingly supplied by substantial retained earnings. The analysis of this article suggests strongly that many managements should now return to the equity markets, not as sellers but as buyers of their common stock, to eliminate excess equity, to rationalize capitalization, and to discipline capital budgeting. Using repurchasing, managers may be able to find new ways to act in the interest of the long-term common stock investor by revitalizing equity capital.

Source: Harvard Business Review, July–August, 1965.