4 Reasons Investors Like Buybacks (2024)

Ultimately, highly successful companiesreach 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.

Key Takeaways

  • 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.

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 earningsamong other factors. In this event, a company will pursue a buyback program since it believes that company shares are undervalued.

See Also
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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 benefit 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 who 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.

4 Reasons Investors Like Buybacks (2024)

FAQs

Why do investors like buybacks? ›

A buyback can benefit 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 who still hold onto the stock; however, buybacks aren't necessarily always good for investors.

What are the benefits of buyback? ›

The effect of a buyback is to reduce the number of outstanding shares on the market, which increases the ownership stake of the stakeholders. A company may buy back shares because it believes the market has discounted its shares too steeply, to invest in itself, or to improve its financial ratios.

What are three reasons a corporation might want to buy back its own stock? ›

However, there are several reasons why it may be beneficial for a company to repurchase its shares, including reducing the cost of capital, ownership consolidation, preserving stock prices, undervaluation, and boosting its key financial ratios.

What is the reason for share buyback? ›

A share repurchase or buyback is a decision by a company to buy back its own shares from the marketplace. A company might buy back its shares to boost the value of the stock and to improve the financial statements. Companies tend to repurchase shares when they have cash on hand and the stock market is on an upswing.

Do investors prefer buybacks or dividends? ›

Dividends Are the Answer

Although some may think that a company paying dividends is a weakness, showing that the company needs to entice investors to invest in the company, dividend payments are much more profitable to investors than company buybacks are. Be sure to also see the Top 10 Myths About Dividend Investing.

What are the pros and cons of stock buybacks? ›

Pros and cons of stock buybacks
Pros of Stock BuybacksPotential Drawbacks of Stock Buybacks
Can make earnings growth look stronger.Reduce available cash on a company's balance sheet.
Can offset dilution from stock-based compensation.Buybacks are now subject to a 1% excise tax.
3 more rows

How do investors benefit from share buybacks? ›

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 is the power of buyback? ›

During the buyback of shares, the price of shares is usually higher than the market price. Buyback of shares can be done either through the open market or through tender offer route. Under the open market mechanism, the company can buy back its shares from the secondary marker.

Are stock buybacks illegal? ›

For most of the 20th century, stock buybacks were deemed illegal because they were thought to be a form of stock market manipulation. But since 1982, when they were essentially legalized by the SEC, buybacks have become perhaps the most popular financial engineering tool in the C-Suite tool shed.

What are at least 3 reasons why an investor might want to purchase stock in companies that grant dividends? ›

Five of the primary reasons why dividends matter for investors include the fact they substantially increase stock investing profits, provide an extra metric for fundamental analysis, reduce overall portfolio risk, offer tax advantages, and help to preserve the purchasing power of capital.

Is share buyback good for shareholders? ›

Share buybacks enable companies to raise shareholder value. Under normal market conditions, the portion of profits a company uses to buy back shares should strengthen its share price.

Has a company ever bought back all its shares? ›

The correct answer is that a buyback of all shares is a liquidation. If there are zero shares, this can only mean the company no longer exists. Note that in normal (partial) buybacks, the company shrinks in value. The natural extreme of this is that the company disappears.

How to profit from stock buybacks? ›

In order to profit on a buyback, investors should review the company's motives for initiating the buyback. If the company's management did it because they felt their stock was significantly undervalued, this is seen as a way to increase shareholder value, which is a positive signal for existing shareholders.

Why buyback instead of dividend? ›

Buybacks are clearly a more tax-efficient way to return capital to shareholders because the investor doesn't incur any additional tax on the buyback sale process. Tax is only applicable on the actual sale of shares, whereas dividends attract tax in the range of 15% to 20%.

Why do shares fall after buyback? ›

Contrary to the common wisdom, buybacks don't create value by increasing earnings per share. The company has, after all, spent cash to purchase those shares, and investors will adjust their valuations to reflect the reductions in both cash and shares, thereby canceling out any earnings-per-share effect.

Why does Warren Buffett like buybacks? ›

The big picture: As Buffett explains, the theory behind buybacks is that they reduce the number of shares outstanding, thereby giving each remaining shareholder ownership of a greater percentage of the company.

Why do companies prefer buybacks over dividends? ›

Advantages of Buybacks

With the reduction in outstanding shares, the Earnings Per Share (EPS) of the company improves. This is a good indication of the company's profitability and may boost its share price in the long run.

What did Warren Buffett say about buybacks? ›

OMAHA, Neb. (AP) — Billionaire Warren Buffett said critics of stock buybacks are “either an economic illiterate or a silver-tongued demagogue” or both, and all investors benefit from them as long as they are made at the right prices.

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