Why Firms Prefer High Stock Price to Low Debt
By John M. Berry
Washington Post Staff Writer
Wednesday, January 27, 1999; Page E01
Something is going to have to give soon on the financial front for nonfinancial corporations, according to economists at Goldman Sachs & Co.
Over the 12 months ended last September, nonfinancial corporations accumulated an additional $359 billion in credit market debt. That was up 72 percent from the rise in the year ended September 1997 and was a record increase for any four-quarter period.
One reason for all the borrowing was that funds generated by the firms internally from profits and depreciation charges all but ceased to grow. At the same time, the corporations continued massive capital spending programs while pursuing the largest stock buyback efforts in history.
As the chart at the right shows, during the depths of the 1990-91 recession, nonfinancial corporations (excluding farms) were shedding debt. As the recovery proceeded, markets improved and heightened competition made it imperative to increase investment, particularly in information- processing equipment such as computers, so the companies began to take on debt again.
All that wasn't particularly unusual. What seems to have been different this time around, according to Goldman Sachs, is the widespread desire to repurchase outstanding shares of stock -- and in the process, boost the value of the remaining shares.
"The main puzzle in this array of data is why U.S. corporations are buying back so much stock at a time when internal cash generation is losing steam and, at least by some widely followed measures, share valuations are unusually high and climbing," Goldman Sachs economist John Youngdahl told his firm's clients recently.
"For example, the ratio of the current market values of equities to corporate net worth has been on a steep upward course for many years and now stands close to 1.2, which is dramatically above the long-term average," Youngdahl said.
On two previous occasions, equity values were that high relative to firms' net worth, both in the late 1960s. But then, Youngdahl said, instead of repurchasing shares, companies took advantage of the high stock prices to issue new shares, "consistent with corporate finance theory."
"Similarly, when profits slumped in 1979 and in 1985-86 in the midst of what were unusually low share valuations, companies followed the theoretical model by lifting borrowing to fund buybacks of what were viewed as relatively cheap shares," he said.
To Youngdahl, this decidedly different response to a slowing in the growth of internally generated funds "lends support to the notion that there has been a clear change in corporate governance philosophy."
What has changed, he believes, is that corporate decisions in this area are being driven significantly by concern about firms' share prices in the short and medium term. That is the result, Youngdahl argued, of the fact that "managers are increasingly evaluated on this basis, and their compensation is more tied to stock and option awards in lieu of money wages and bonuses."
"To the extent that defense of the share price has assumed relatively high importance, it stands to reason that firms would be more willing to employ their borrowing flexibility to fund equity repurchases even when traditional valuation measures look high," he said.
The high level of stock prices, in turn, helps justify the high level of investment in new plants and equipment. With many firms' market value exceeding the replacement cost of their capital, it makes more sense to add to that capital base than to purchase existing assets by buying shares in another firm, at least in theory.
Whether corporate executives are thinking in such theoretical terms isn't clear. But whatever is going on, they have continued to increase spending on new plants and equipment despite deteriorating fundamental financial conditions at many firms.
In addition, investment spending hasn't tapered off, as it normally does, when the share of total production capacity actually in use declines noticeably, as happened in the second half of last year.
In effect, these nonfinancial corporations find themselves unable to fund everything they wish. The response to this squeeze thus far has been to take on more debt and, in many instances, to reduce labor costs by trimming payrolls. The latter is possible partly because of the productivity gains that result for the high level of capital investment.
Youngdahl and many other economists think corporate executives won't be able to continue for long to finance both ever greater investments and the ongoing share buybacks.
"Bond markets and bank lenders will take a dim view of rapid private-sector debt additions under these circumstances" with borrowers having to pay higher interest rates to obtain funds and lenders likely to make less credit available than was the case in recent years, he said.
So what will be the corporate response?
"I think when push comes to shove, investment will give first," Youngdahl said. The incentives pushing managers in the direction of supporting share prices haven't changed, and in a world of declining use of production capacity, the return to a firm on a new investment could easily turn out to be negative.
"In the end, they may be forced to do both" -- cut investment plans and curtail the stock buybacks, he said.
In the latest Goldman Sachs forecast for the U.S. economy, capital spending turns down late this year, a projection that predated Youngdahl's analysis but is reinforced by it.
With profits flat or sagging, U.S. nonfinancial corporations last year took on the largest amount of debt in history to finance large stock-buyback plans and capital investments programs. Some economists suggest firms may be forced to cut back on one program or both.
'98 $359 billion
NOTE: Figures are for fiscal years ending in September.
SOURCE: Goldman Sachs and the Federal Reserve
© Copyright 1999 The Washington Post Company
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