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.

Stock Buyback: Overview

A stock buyback, also known as a share repurchase, is when a company uses excess cash to buy back its own shares from the market. This approach is intended to boost shareholder value by decreasing the number of shares available, which may increase earnings per share and potentially raise the stock price.

Shares that are repurchased can be either canceled or retained in treasury. If shares are canceled, they become ineligible for dividends and voting rights, which means they no longer play a part in the company’s equity structure.

Stock buybacks can spark debates. Some critics believe these actions may inflate a company's financial performance metrics and divert funds from potentially more beneficial investments like research and development or employee pay. By focusing on repurchasing shares instead of growth initiatives, companies might compromise long-term value creation, resulting in ongoing discussions about the advantages and disadvantages of this practice in corporate finance.

Financial Implications of Stock Buybacks on Investors

Stock buybacks, or share repurchase programs, are strategies used by companies to manage their finances and increase shareholder value. When a company buys back its shares, it reduces the number of shares available in the market. This can lead to higher earnings per share and potentially raise the stock price. Buybacks may signal that a company is confident in its future and thinks its shares are undervalued. However, the impact of stock buybacks can be complex. While they can improve short-term returns, some critics argue they focus too much on immediate profits instead of long-term growth and innovation. Investors should understand how buybacks can affect share value, market perception, and investment strategy. The next sections will discuss the financial effects of stock buybacks, detailing the benefits and potential drawbacks for investors.

Increased Ownership Stake

Stock buybacks are a financial strategy that affects a company's outstanding shares. When a company buys back its own shares, it reduces the number of shares available to the public. This decrease in supply increases the ownership percentage for existing shareholders. With fewer outstanding shares, each share represents a larger portion of the company. This can lead to a higher valuation per share. Consequently, shareholders benefit from enhanced equity stakes. This can increase their influence over corporate decisions and the potential for greater financial returns.

Higher ROI

Supply and demand are key factors in stock pricing. When a company buys back its shares, it reduces the number of outstanding shares. This can create a situation where demand exceeds supply. As shares become scarcer, their prices may rise over time. Investors often view buybacks as a sign of a company's strong financial health. This perception can further increase demand for the stock. When shareholders sell their shares after a buyback, they may see a return on investment (ROI) that is better than expected. Additionally, if the stock price goes up before the buyback, shareholders who sell in the open market can benefit significantly. This improves the attractiveness of the investment.

Increased Portfolio Earning Potential

Stock buybacks impact earnings per share (EPS) significantly. When a company repurchases its shares, the number of outstanding shares decreases. This results in total earnings being divided among fewer shares, which raises EPS. Buybacks can also lower the price-to-earnings (P/E) ratio. A lower P/E ratio may indicate that a stock is undervalued based on its earnings potential, making it more attractive to investors.Additionally, the cash used for buybacks reduces a company's assets on the balance sheet. This can improve financial ratios like return on assets (RO A) and return on equity (RO E), signaling profitability and better capital structure. As a result, stocks that conduct buybacks may be seen as promising investments. For investors, adding these stocks to their portfolios can boost diversification and profit potential.

Tax Benefits

In the past, stock buybacks have been an efficient method for companies to return value to shareholders without being taxed at the corporate level, unlike dividends. However, following the introduction of President Biden's Inflation Reduction Act of 2022, companies now face a 1% excise tax on stock buybacks exceeding $1 million. While this adds a new tax responsibility, it is still less onerous than the double taxation that dividends face, thus keeping buybacks an appealing option for returning capital.

Portfolio Assets Devaluation

Stock buybacks can create a positive market impression. However, they have downsides. Some companies use buybacks to inflate their share prices. This often occurs when they struggle to grow organically. It may signal to investors that the company has peaked. This raises concerns about long-term sustainability. The immediate share price increase after a buyback can attract short-term investors. However, long-term investors may face risks. This situation can lead to a misleading narrative. It may look like earnings are increasing due to real growth. In reality, it may stem from financial strategies. Long-term shareholders could face significant risks and potential losses if the company’s fundamentals do not support higher valuations.

What Should Investors Do After a Stock Buyback?

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:

Sell Your Shares Back to the Company

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.

Keep Your Shares

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.

Buy the Shares to Flip at a Higher Price 

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.

Why Do Companies Buy Back Stock?

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

Directly Boost Share Prices

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.

Offset Dilution

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.

Hostile Takeover Defense

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.

Keep Investors Happy

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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