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Ultimately, highly successful companies reach a position where they are generating more cash than they can reasonably reinvest in the business. The financial crisis has 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 recently demonstrated by Apple’s (APPL) capital return programs.

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, similarly to how investors purchase stocks. While there has been a clear shift in wealth distribution of dividends to stock repurchasing, this doesn’t mean a company cannot pursue both.

Apple investors have grown to prefer buybacks since they 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. From a financial perspective, buybacks benefit investors by improving shareholder value, increasing share prices, and creating tax beneficial opportunities.

Improved Shareholder Value

There are many ways profitable companies can measure the success of its 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 buyback, 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.

Boost in Share Prices

When the economy is faltering, share prices can plummet as a result of weaker than expected earnings amongst 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 increase 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.

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.

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

While investors tend to adore buybacks, there are several disadvantages investors should be aware of. Buybacks can be a signal of the marketing 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 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.

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