What is a Stock Buyback?

When a company or corporation is flush with cash and has spending flexibility, it may pump money into R&D and capital expenditures. The company may acquire other companies or return money to its shareholders. A stock buyback is a way a company returns cash to investors. An alternative approach is by paying dividends.

 S&P 500 companies bought back  $212 billion of their own stock in Q3 2022, down from $519.8 billion in 2020 and from the record $806.4 billion 2018 level. A significant percentage of these buybacks comes from a handful of companies, with Apple, Facebook parent Meta, Google parent Alphabet, Microsoft and Bank of America leading the pack — the so-called buyback monsters.

While buybacks boost a company’s earnings per share (EPS) and increase the market value of executives’ stock options, critics argue that it stalls business investment. Among these critics include Democratic Senators Chuck Schumer and Bernie Sanders, both of whom, in a New York Times Op-ed, argued that buybacks restrain companies from investing in R&D, paying higher wages, providing equipment and conducting training. Benzinga breaks down what a stock buyback is and how it benefits the investor.

A buyback or stock repurchase can impact investors in various ways. While the overall impact is positive, a few drawbacks must be taken into consideration. Here are some of the core ways a stock buyback impacts investors.

Stock buybacks reduce the company’s outstanding shares or its share supply to the market. Fewer outstanding shares or owners mean that each unit of shares will then represent higher fractional ownership and valuation. The shareholder or investor will own a more significant percentage of equity after a buyback.

Supply and demand play a key role in how stocks are priced. A decline in the number of outstanding shares triggers a price increase and vice versa. Share prices typically rise when there is a higher demand and a lower supply of shares. And since a buyback reduces share supply, it usually raises the stock’s price over time.

Buybacks boost some of the core metrics investors use to evaluate a firm, enhancing its overall positive view in the market. This practice could drive up the demand and attendant share price. And when you finally sell, you may gain a more-than-optimum return on investment (ROI). Additionally, suppose the stock price rises before the repurchase. In that case, individuals who sell their shares on the open market could also benefit.

By reducing outstanding shares, the company’s EPS should increase significantly. However, besides the EPS, a stock buyback also lowers the price-to-earning (P/E) ratio, which measures the share price relative to the EPS and can help determine the company’s share value during an apples-to-apples comparison. A lower P/E is considered excellent.

Buybacks lower the amount of cash on a company’s balance sheet. Because the company’s monetary assets have been reduced, the return on assets increases. Return on equity also rises because of fewer outstanding shares.

The increased potential that the general investing community perceives as a result of these indicators elevates the company shares to the status of a high-potential investment. And as an investor, including such assets in your portfolio not only makes for diversification but also raises the total profit potential of your portfolio.

Before the signing of President Biden’s Inflation Reduction Act of 2022, companies weren’t taxed for boosting value for their investors through buybacks, unlike dividends that were taxed at a corporate level as a profit and at the investor’s level when received as income. However, once the new law became effective on Dec. 31, 2022, companies pay an excise tax of 1% for stock buybacks above $1 million.

Because some companies may execute buybacks to inflate share values, buybacks can be a warning that the market has topped out. When earnings cannot be increased, some executives may approve leveraging buybacks to temporarily improve profitability because executive compensation is typically based on earnings criteria.

Additionally, a gain in the share price following the announcement of buybacks often benefits short-term investors rather than those looking for long-term value. This factor gives the market a misleading impression that earnings are increasing because of organic growth. Investors who choose to hold on to these investments risk suffering substantial losses.

A repurchase could benefit shareholders if a public firm operates optimally, has cash on hand and is undervalued. However, when a company focuses on a buyback to satisfy the profit needs of its executives while ignoring factors that fuel growth, it will fail long-term. Therefore, investors must get the complete picture before committing to a buyback.

When a company announces its intention to buy back shares, the short-term buzz will send the stock price on a bullish run. Given this scenario, you can choose to:

If you’re a short-term investor, selling your shares at an exponentially higher price (bullish market price + premium offered by the company) to maximize the potential short-term benefits may align with your investment goals.

Buybacks reduce outstanding shares such that the share value of the available shares increases. If you’re keen on increasing your ownership stake in the company, you would keep your shares. Also, suppose your investment approach is oriented toward the long term. In that case, you may gain better value by holding your shares.

Once you’re sure about the prospects of the target company, you could buy the company shares at a low price when the announcement hits the press, then attempt to sell for a higher price after the price has consolidated.

From boosting share prices to redistributing wealth, a company can undertake to buy back for diverse reasons. Here are some of the core reasons.

Delivering a higher share price is the core objective of most buybacks. The board may also decide to buy the company’s stock if it believes it is undervalued and thus an excellent time to buy. The news of the stock buyback also serves as a vote of confidence in the market, signifying that overall the company has a positive growth prospect. This makes sense since, ordinarily, most companies wouldn’t have the motivation to purchase their shares if it’s sinking.

Growing businesses may find themselves competing for talent. Suppose they grant stock options to employees to retain them. In that case, the options exercised over time increase the company’s total number of outstanding shares — and dilute current shareholders’ stake. Stock buybacks are an effective strategy to counteract this effect.

During a potential hostile takeover, the target company’s management can repurchase part of its shares to reduce the likelihood that a potential bidder will be able to acquire a controlling stake. Additionally, businesses may use the poison pill defense, which allows current shareholders to buy additional shares at a reduced price, reducing the opposing party’s ownership stake in the process.

Companies also execute buybacks to keep investors pleased, as capital distribution is one of the primary ways for investors to profit. The purpose of a company’s management is to maximize shareholder return, and a stock repurchase typically raises shareholder value.

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