Ultimately, highly successful companies reach a position where they are generating more cash than they can reasonably reinvest in the business. The financial crisis caused investors to pressure companies to distribute the accumulated wealth back to shareholders.
Typically, companies can return wealth to shareholders through stock price appreciations, dividends, or stock buybacks. In the past, dividends were the most common form of wealth distribution; however, as Corporate America becomes more progressive and flexible, a fundamental shift has occurred in the way companies deploy capital.
Instead of traditional dividend payments, buybacks have been viewed as a flexible practice of returning excess cash flow. Buybacks can be seen as an efficient way to put money back into its shareholders' pockets, as demonstrated by Apple’s (AAPL) capital return programs.
- A stock repurchase, or buyback, occurs when a company uses cash on hand to buy and retire some of its own shares in the open market.
- Buybacks tend to boost share prices in the short-term, as the buying reduces the supply of outstanding shares and the buying itself bids the share higher in the market.
- Shareholders may view buybacks as a signal of corporate health and optimism from company managers that their shares are undervalued.
- There's been a large rise in buybacks, with some companies looking to take advantage of undervalued stocks, while others do it to artificially boost the stock price.
How Does a "Buyback" Work?
The Basics of Buybacks
In recent history, leading companies have adopted a regular buyback strategy to return all excess cash to shareholders. By definition, stock repurchasing allows companies to reinvest in themselves by reducing the number of outstanding shares on the market. Typically, buybacks are carried out on the open market, similar to how investors purchase stocks.
Investors have the choice of whether or not to partake in the repurchase program. By not participating in a share buyback, investors can defer taxes and turn their shares into future gains. Buybacks benefit investors by increasing share prices, effectively returning money to shareholders in a tax-efficient manner.
1. Improved Shareholder Value
There are many ways profitable companies can measure the success of their stocks; however, the most common measurement is earnings per share (EPS). Earnings per share are typically viewed as the single most important variable in determining share prices. It is the portion of a company’s profit allocated to each outstanding share of common stock.
When companies pursue share buybacks, they will essentially reduce the assets on their balance sheets and increase their return on assets. Likewise, by reducing the number of outstanding shares and maintaining the same level of profitability, EPS will increase.
For shareholders who do not sell their shares, they now have a higher percent of ownership of the company’s shares and a higher price per share. Those who do choose to sell have done so at a price they were willing to sell at.
2. Boost in Share Prices
When the economy is faltering, share prices can plummet as a result of weaker than expected earnings among other factors. In this event, a company will pursue a buyback program since it believes that company shares are undervalued.
Companies will choose to repurchase shares and then resell them in the open market once the price increases to accurately reflect the value of the company. When earnings per share increases, the market will perceive this positively and share prices will increase after buybacks are announced. This often comes down to simple supply and demand. When there is a less available supply of shares, then an upward demand will boost share prices.
3. Tax Benefits
When excess cash is used to repurchase company stock, instead of increasing dividend payments, shareholders have the opportunity to defer capital gains if share prices increase. Traditionally, buybacks are taxed at a capital gains tax rate, whereas dividends are subject to ordinary income tax. If the stock has been held for more than one year, the gains would be subject to a lower capital gains rate. The capital gains tax is levied against the shareholder selling their stock to the company.
4. Utilize Excess Cash
When companies pursue buyback programs, this demonstrates to investors that the company has additional cash on hand. If a company has excess cash, then at worst the investors do not need to worry about cash flow problems. More importantly, it signals to investors that the company feels cash is better used to reimburse shareholders than reinvest alternative assets. In essence, this supports the price of the stock and provides long-term security for investors.
The Downside of Buybacks
While investors tend to adore buybacks, there are several disadvantages investors should be aware of. Buybacks can be a signal of the market topping out; many companies will repurchase stocks to artificially boost share prices.
Typically, executive compensations are tied to earnings metrics and if earnings cannot be increased, buybacks can superficially boost earnings. Also, when buybacks are announced, any share price increase will typically benefit short-term investors rather than investors seeking long-term value. This creates a false signal to the market that earnings are improving due to organic growth and ultimately ends up hurting value.
The Inflation Reduction Act of 2022 was passed in August of 2022 and stipulated that domestic public companies would be charged a 1% excise tax on buybacks.
Are Buybacks Good for Investors?
A buyback can be good for investors because they receive their capital back and are often paid a premium over the stock's market price. In addition, there is a boost in the share price for investors that still hold onto the stock; however, buybacks aren't necessarily always good for investors. Buybacks falsely inflate the share price, meaning the boost is temporary. Also, buybacks may not always be the best use of capital for a company, which may hurt its value down the road, adversely impacting investors.
Do You Have to Sell Your Shares in a Buyback?
No, you don't have to sell your shares in a buyback; a company cannot force you to do so. Companies, however, offer a premium for the shares to entice shareholders to sell their shares back to the company.
Are Share Buybacks Taxed?
Yes, share buybacks are taxed. Shareholders that sell their shares back to a company have to pay a capital gains tax on their earnings. Additionally, companies have to pay a 1% excise tax on the buyback.
The Bottom Line
Generally speaking, redistributing wealth has been viewed positively by investors. This can come in the form of dividends, retained earnings, and the popular buyback strategy. In terms of finance, buybacks can boost shareholder value and share prices while also creating a tax-advantageous opportunity for investors. While buybacks are important to financial stability, a company’s fundamentals and historical track record are more important to long-term value creation.