Public companies often reward their shareholders via excess cash. This often comes in the form of dividends, but it can also come in the form of stock buybacks.
When a company buys back its own shares, the move can drive up the stock price. But these repurchases are also controversial.
What is a stock buyback?
A stock buyback, also called a share repurchase, is when a company uses excess cash to repurchase shares of its stock from the public market. This is a way to return money to shareholders.
Typically, a company will announce that its board of directors has approved a “repurchase authorization.” The announcement will include details like the percentage of the shares on the open market the company intends to buy back, or the amount of money the business will spend on the buybacks.
Then, shareholders decide whether or not they want to sell their shares back to the company. They don’t have to.
While stock buybacks are intended to create value for shareholders, they’re a controversial move. Critics say buybacks can result in an artificial boost for the company’s financials and that they don’t always result in a positive outcome for shareholders.
Why do companies buy back their own stocks?
While the main purpose of a stock buyback is to provide value to shareholders, several factors go into a company’s decision to repurchase shares. A company may buy back its own stock to:
- Drive up the share price: Companies may buy back their own shares if they feel the stock is undervalued — as in, trading at a price lower than what it’s worth. Stock prices move based on changes in supply and demand, and by buying its own stock, a company reduces supply and essentially makes the remaining shares more valuable on a relative basis. The move can also indicate that the company is confident in the stock, which can thereby boost investors’ confidence in the stock and encourage them to buy shares.
- Give back to shareholders with flexibility: While stock dividends are appealing to investors, they don’t come with much flexibility for the company issuing them. If a company cuts its dividend or does not make dividend payments to investors as they expect, on certain dates and in set amounts, shareholders will almost always push the stock price lower. On the other hand, a company may authorize a one-off stock buyback or make changes to its buyback program as needed without much impact on investor sentiment.
- Return value in a tax-friendly way: While most dividends are taxed as ordinary income, investors don’t pay taxes on stock buybacks unless they sell their shares to the company and face capital gains tax. If they don’t sell, they don’t pay taxes — but they could still see the share price get a boost.
- Counteract the effect of stock options: Many companies offer stock options to employees as a way to attract talent. Those stock options can increase the number of shares on the public market when they’re exercised, and buying back stock is a way for management to keep the number of shares on the market at a preferred level.
How stock buybacks affect a company’s value
Analysts use various metrics to measure the value of a stock, including earnings per share (EPS), which is calculated by dividing a company’s total profit, minus preferred dividends, by the number of outstanding shares, and the price-to-earnings (P/E) ratio, which is determined by dividing a stock’s share price by its EPS.
When a company buys back its shares, those shares are no longer outstanding on the public market, which means the repurchasing can affect fundamentals like EPS and the P/E ratio — and possibly make a company look more attractive than it is.
Buybacks can also indicate how upper management feels about a stock. If investors see a business repurchasing its own shares, they may interpret it as a vote of confidence in the company’s future.
The tax implications of stock buybacks
In 2023, a new 1% tax on stock buybacks went into effect as part of The Inflation Reduction Act of 2022, increasing the tax burdens companies face when they choose to repurchase shares of their own company.
But the new tax on corporate stock buybacks hasn’t affected buyback programs to a noticeable degree, says Christopher Barto, investment analyst at Fort Pitt Capital Group.
“If the markets are efficient in any way, this 1% tax is already priced into the market,” Barto says. “A management team is not going to have a make-or-break decision on whether to return capital to shareholders through buybacks because of a 1% tax.”
But if the tax were increased to 4%, which President Joe Biden proposed in his 2023 State of the Union address, that could spark a different story in terms of capital allocation at certain companies, Barto adds.
The downsides of stock buybacks
While buybacks are often seen as a positive for shareholders, they can have their downsides, too.
If a company approves a poorly-timed buyback — for example, when its stock price is high and the financials are healthy — the repurchasing could cause prices to drop or signal to investors that the company doesn’t have growth opportunities to invest in.
Another potential disadvantage of stock buybacks is opportunity cost. When a company issues a stock buyback program, it’s typically done because management believes it’s a good use of capital for shareholders.
But it could also disrupt any potential investments or acquisition potential down the road, says Barto. Critics of stock buyback programs also say that using funds to boost a company’s share price via buybacks can come at the expense of reinvesting in productivity operations or growing the workforce.
Companies may also face challenges when financing the buybacks with debt. While the move can make sense, it’s dependent on the business’s current financial situation.
“A company with unstable free cash flow that issues debt to fund buybacks can run into issues down the road,” Barto says.
Finally, buyback critics say that when companies give stock-based compensation to managers, buybacks can hurt shareholders. This is because the issuance of new stock to managers may dilute shareholders’ overall ownership, and buybacks can disguise the impact.
How rising interest rates impact stock buybacks
In the years following the 2008 financial crisis, the Federal Reserve kept interest rates low. But beginning in early 2022, in the face of high inflation, the central bank began to increase interest rates and ultimately pushed them to their highest level in more than two decades.
Higher rates can hurt share buyback programs if those programs are funded by debt because when interest rates are as high as they are now, borrowing money to finance share buybacks becomes expensive, Barto says. He adds that it’s a strong reason to look for businesses that use their free cash flow, rather than debt, to return money to shareholders.
In 2023, stock buybacks slowed for various reasons, including businesses revisiting capital budgets for the year and focusing on cost-cutting scenarios, Barto adds.
Frequently asked questions (FAQs)
Stock buybacks are often used as a way to reward shareholders. Those who choose to sell will receive cash from the company, and those who don’t will likely see a boost in the overall stock price. However, buybacks aren’t always positive for investors, as described above.
A stock buyback can impact important metrics like a company’s EPS and P/E ratio —both of which are used to measure a company’s financial health.
As of 2023, companies face a 1% tax on total market value of the repurchased stock when they decide to repurchase their own shares.
High interest rates make it more expensive to borrow money. This can impact stock buybacks because companies may be less likely to use debt to finance buybacks when rates are high and because they may be more focused on cutting costs than repurchasing shares.
