Profitable public companies often return excess cash to shareholders by paying dividends. But they can also reward their investors another way: stock buybacks, also known as share buybacks or share repurchase programs.
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What Is a Stock Buyback?
A stock buyback is when a public company uses cash to buy shares of its own stock on the open market. A company may do this to return money to shareholders that it doesn’t need to fund operations and other investments.
In a stock buyback, a company purchases shares of stock on the secondary market from any and all investors that want to sell. Shareholders are under no obligation to sell their stock back to the company, and a stock buyback doesn’t target any specific group of holders—it’s open to anybody.
Public companies that have decided to do a stock buyback typically announce that the board of directors has passed a “repurchase authorization,” which details how much money will be allocated to buy back shares—or alternatively the number of shares or percentage of shares outstanding it aims to buy back.
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Why Do Companies Buy Back Their Own Stock?
The main reason companies buy back their own stock is to create value for their shareholders. In this case, value means a rising share price.
Here’s how it works: Whenever there’s demand for a company’s shares, the price of the stock rises. When a company buys its own shares, it’s helping to increase the price for its stock by boosting demand, thereby creating value for all shareholders.
One of corporate America’s highest goals is to maximize shareholder value. According to this principle, a company should always aim to generate the highest possible returns for its investors. Increasing the value of its stock and returning cash to holders—in the form of dividends and share buybacks—is how companies maximize value for shareholders.
While dividend payments are perhaps the most common way to return cash to shareholders, there are advantages to stock buybacks:
- Directly boost share prices. The main goal of any share repurchase program is to deliver a higher share price. The board may feel that the company’s shares are undervalued, making it a good time to buy them. Meanwhile, investors may perceive a buyback as an expression of confidence by the management. After all, why would a company want to buy back stock it anticipated to decline in value?
- Tax efficiency. Dividend payments are taxed as income whereas rising share values aren’t taxed at all. Any holders who sell their shares back to the company may recognize capital gains taxes, naturally, but shareholders who do not sell reap the reward of a higher share value and no additional taxes.
- More flexibility than dividends. Any company that initiates a new dividend or increases an existing dividend will need to continue making payments over the long term. That’s because they risk lower share values and unhappy investors if they reduce or eliminate the dividend going forward. Meanwhile, since share buybacks are one-offs, they are much more flexible tools for management.
- Offset dilution. Growing companies may find themselves in a race to attract talent. If they issue stock options to retain employees, the options that are exercised over time increase the company’s total number of shares outstanding—and dilute existing shareholders. Buybacks are one way to offset this effect.
How Stock Buybacks Affect a Company’s Value
Since stock buybacks remove cash from a company’s balance sheet and potentially reduce the number of shares outstanding, they can have a wide impact on the key metrics investors use to value a public company.
It’s important to understand that once a company has bought back its own shares, they are either canceled—thereby permanently reducing the number of shares outstanding—or held by the company as treasury shares. These are not counted as shares outstanding, which has implications for many important measures of a company’s financial fundamentals.
Key metrics like earnings per share (EPS) are calculated by dividing a company’s net profit by the number of shares outstanding. Reduce the number of shares outstanding and you’ve given a company a higher EPS, which may make the company appear to be performing better.
The same thing goes for the price-to-earnings ratio (P/E ratio), which helps investors understand a company’s relative valuation by comparing its stock price to its EPS.
Biggest Stock Buybacks of 2024
Let’s take a look at the top five largest stock buybacks announced in 2023, ranked by total dollar value.
*All data sourced from Marketbeat.com
Disadvantages of Stock Buybacks
There are many critics of stock buybacks who call them a poor way for companies to create value for their shareholders. Here are some of the downsides to stock buybacks:
- Poor use of cash. Depending on many factors, stock buybacks may privilege short-term gains in share price when other more profitable uses of the cash are available. Investing in research and development or simply stockpiling cash for a rainy day may not help share prices, but they could offer better value over the longer term.
- Debt-fueled share buybacks. In the years before the Covid-19 pandemic upset the economy, up to half of all buybacks were financed by taking out debt. Low interest rates incentivized companies to borrow money to spend on share buybacks to benefit stock prices in the short term. Many critics suggest this was an especially shortsighted strategy.
- Cash-rich companies tend to have high stock prices. Some companies launching stock buybacks have built up a warchest of cash after a period of good performance. Companies in this position also tend to have relatively high share valuations, meaning they may be producing less value for shareholders than other uses of the cash.
- Used to conceal stock-based compensation to executives. Many public companies issue compensation to managers in the form of stock, which dilutes other shareholders. Executives may use buybacks to obscure how this form of compensation impacts the company’s share count.
What Stock Buybacks Mean for You
If you invest in individual stocks and are wondering if a stock buyback is good news or not, think about it this way. If a public company is doing well, has cash to spare and its shares are undervalued, then a buyback could be a positive for shareholders.
But if a company is repurchasing shares of stock while it ignores other parts of the business or holds back on investing in its future growth, it’s a decision that will likely cost shareholders value in the future.
If a company’s shares are overvalued, shareholders like you would be better served by the company hanging on to the cash for a rainy day.
Stock Buyback FAQs
Are stock buybacks good for shareholders?
Public companies use share buybacks to return profits to their investors. When a company buys back its own stock, it’s reducing the number of shares outstanding and increasing the value of the remaining shares, which can be a good thing for shareholders.
What’s the difference between a dividend and a share buyback?
Public companies typically use both share buybacks and dividend payments to return excess profits to investors. With dividends, a company makes cash payments directly to its shareholders. With share buybacks, companies offer to buy their shares back from shareholders.
Why not return capital to shareholders through dividends only?
Share buybacks let shareholders choose whether they want to receive cash or not, which has implications for annual income ] and income taxes. Dividends return cash to all shareholders, regardless of their preferences—when a company pays a dividend, every shareholder receives cash. With stock buybacks, investors can elect to sell their shares—or not.
Can the company force me to sell my shares?
No, a public company cannot require you to sell shares as part of a share buyback program.
How can I profit from share buybacks?
When a company announces that its board of directors has authorized a new share buyback program, the company’s share price may immediately increase in value. Companies generally do not disclose when they carry out the share buybacks authorized by the board, but traders can profit from share buyback by purchasing stock when the buyback announcement is disclosed.
