5. Executive Compensation

Another reason why firms might prefer buybacks over dividends is related to the their compensation policies. In this context, at least two arguments are relevant:

  • Ownership dilution due to executive stock option plans (ESOP)
  • Dividend protection of executive stock options

  

ESOPs and Ownership Dilution

For many listed firms, stocks or stock options are an integral part of their management compensation packages. As a result, these firms have to frequently make additional shares available for their managers.

Of course, these firms could issue new shares, but that would dilute the ownership structure and, as a consequence, also the firm's earnings per share (EPS). Often, firms therefore prefer to repurchase shares from existing shareholders. In fact, a substantial part of the buyback programs are motivated by these executive compensation considerations.

This is important to remember, because if the repurchased shares are redistributed to managers at a later stage, the number of shares outstanding does actually not decrease. Therefore, the part of the repurchase program that is designed to support executive compensation is neutral to EPS. And it is only beneficial to the repurchasing firm if the repurchased shares are more valuable when held by the managers (for example because of an increased incentive to work hard or because it allows firms to attract and retain key personnel). 

 

Dividend Protection of Executive Stock Options

Another reason why buybacks could be preferable is related to the valuation of executive stock options. From option pricing, we know that the value of a call option is a positive function of the stock price: The higher the stock price, the more valuable the right to buy stock in the future at a predefined price. From before, we also know that the stock price will drop by the (after-tax) amount of dividend at the ex-dividend date. 

Executive stock options are often not protected against this dividend effect on stock prices. Therefore, paying out (extraordinary) large dividends could not be in the best interest of the managers because it lowers the value of their compensation package.