Are stock buybacks good for investors?

It depends. When companies use stock buybacks responsibly, they can be a positive catalyst for investors, both in the short and long term. For example, if a stock declines due to market weakness and management sees the company's true or intrinsic value as greater than the current stock price, buying back stocks could be a great way to use excess profits to generate shareholder value. Buybacks can also increase a company's earnings per share (EPS) and help offset dilution -- for example, through employee stock-based compensation. On the other hand, buybacks done just to boost a company's EPS or done regardless of price or valuation could potentially be a negative driver of long-term value. For example, many companies are flush with cash in strong economic environments, but their valuations are also high. Indiscriminately buying back stock in cases like this can result in the company overpaying for its shares and eroding value over time. It's also worth noting that there's a big difference between shares bought back with cash and shares repurchased with borrowed money. The latter can be a red flag that the company is doing a buyback just to improve some of its metrics and not because it's in the best interest of shareholders.

What happens when a company buys back its stock?

When a company buys back stock, it simply repurchases shares on the open market, much like you or I would buy shares of a stock. In some cases, companies buy back stock directly from shareholders in a process known as a tender offer. In either case, when a company buys back shares, it simply absorbs those shares into its business, and they cease to trade on the open market. For example, if a company has 1 million shares of stock outstanding and buys back 10,000, it will then have 990,000 outstanding shares.

Do buybacks increase stock price?

Stock buybacks can increase stock prices, but it's not automatic. For example, stock buybacks can increase earnings per share since fewer outstanding shares exist, but they do so at the expense of cash on the balance sheet, which is also typically factored into valuation. If anything, responsible buybacks can be a driver of long-term stock price increases if management buys back shares for less than their intrinsic value.

Stock Buybacks: Why Do Companies Repurchase Shares?

What Are Stock Buybacks?

Key Points

U.S. companies spent $773 billion on stock buybacks in 2023, expected to spend $885 billion in 2024.
Stock buybacks increase a company's earnings per share by reducing outstanding shares.
Buybacks offer a tax-efficient way to return capital to shareholders compared to dividends.

Over the past couple of decades, stock buybacks have become a big part of how companies use their profits to return capital to shareholders. While buybacks remain below their all-time high, U.S. companies spent $773 billion buying back their own shares in 2023 and are expected to buy back $885 billion in stock throughout 2024.

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A graphic listing reasons to buy back shares of stock, including un-diluting the stock and increasing earnings per share. — Image source: The Motley Fool.

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The stock is undervalued

//If you could buy a $100 bill for $50, wouldn't you do so as often as possible? That's essentially one of the biggest reasons companies choose to buy back stock.

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Intrinsic Value

The intrinsic value of a stock is its true value. It refers to what a stock (or any asset, for that matter) is actually worth -- even if some investors think it's worth a lot more or less than that am

If a company's board of directors thinks its stock is trading for a significant discount to its intrinsic value, it may choose to act aggressively with buybacks. We've seen this quite a bit in the financial sector in recent years, and this is the reason Warren Buffett has given regarding Berkshire Hathaway's (BRK.A +0.50%)(BRK.B +0.45%) stock buybacks.

For example, during the 2022 bear market, many companies in industries and sectors that historically don't buy back shares -- such as rapidly growing tech companies and real estate investment trusts (REITs) -- implemented buyback programs. The most common reason cited was that management believed the stock was a bargain relative to its intrinsic value.

An (almost) tax-free way to return capital

Dividends are generally taxable income unless you own stock shares in a tax-advantaged account, such as an individual retirement account (IRA). To be sure, the tax rates imposed on most dividends are better than those on ordinary income, but we're still talking about a tax hit on dividends between 15% and 23.8% for most investors.

Meanwhile, when a company uses excess profits to buy back stock, it doesn't create a taxable event for shareholders. It's worth noting that the recently passed Inflation Reduction Act contained a 1% excise tax on buybacks (assessed on the company), but this is still far less than the tax hit investors would face if the company chose to pay it out as a dividend instead.

Increase earnings per share

Companies generally don't like to acknowledge this one, but the reality is that buybacks can make a company's earnings growth appear better than it actually is. Let's say that Company X has 10 million outstanding shares and earns $20 million in profit this year. Simple math shows that its earnings per share (EPS) for the year was $2.

However, let's say the company buys back 1 million shares of stock -- reducing its share count to 9 million -- and earns $20 million again next year. Now, because there are fewer shares, the company's earnings are $2.22 per share. It appears that earnings grew by 11%, even though the company generated the exact same amount of profit.

It's easier to cut buybacks in tough times

If you're a new investor, you might not realize this yet, but few ways to lower a stock's price are as reliable as cutting a longstanding dividend. As a result, companies often don't start or increase a dividend unless they're fairly certain the payout will be sustainable.

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Pros and cons of stock buybacks. Chart by author.

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The bottom line on stock buybacks

In most cases, companies returning capital to shareholders, either in the form of buybacks or dividends, is a good thing. In many ways, buybacks have some significant advantages over dividends, especially if the stock is truly trading for less than its intrinsic value.

Stock Buyback FAQ

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About the Author

Matt Frankel, CFP, is a contributing Motley Fool stock market analyst and personal finance expert covering financial stocks, REITs, SPACs, and personal finance. Prior to The Motley Fool, Matt taught high school and college mathematics. He holds a bachelor’s degree in physics from the University of South Carolina, a master’s degree in mathematics from Nova Southeastern University, and a graduate certificate in financial planning from Florida State University. He won a SABEW award for coverage of the 2017 Tax Cuts and Jobs Act. He is also regularly interviewed by Cheddar, The National Desk, and other TV networks and publications for his financial, stock market, and investing expertise.

TMFMattFrankel

@MattFrankelCFP

Matt Frankel has positions in Berkshire Hathaway. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.

How stock buybacks affect the market

Stock buybacks don't directly affect the market or investors, aside from perhaps lowering dividends. When it comes to investors, buybacks can be a fantastic way to create value, especially if they're done for the right reasons, such as a stock trading for less than its intrinsic value.

Although stock buybacks technically just move money from one place (a company's balance sheet) to another, they often increase a stock's price. As mentioned, buybacks can make earnings growth look significantly stronger than it truly is, and investors use metrics such as earnings growth rates and the price-to-earnings (P/E) ratio when valuing companies.

Pros and cons of stock buybacks

Generally speaking, stock buybacks are a shareholder-friendly way to use capital. But like most investing topics, there are pros and cons and good and bad ways to use stock buybacks. For example, many companies buy back stock regardless of price or valuation and can end up paying more than intrinsic value, especially in strong market environments.

With that in mind, here's a list of some of the pros and cons of stock buybacks that investors should be aware of:

What Are Stock Buybacks?

Key Points

The stock is undervalued

Intrinsic Value

An (almost) tax-free way to return capital

Increase earnings per share

It's easier to cut buybacks in tough times

The bottom line on stock buybacks

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Stock Buyback FAQ

About the Author

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Stock Buyback FAQ

Are stock buybacks good for investors?

What happens when a company buys back its stock?

Do buybacks increase stock price?

Understanding stock buybacks

Why do companies buy back their shares?

The stock is undervalued

Un-diluting the stock

How stock buybacks affect the market

Pros and cons of stock buybacks

The bottom line on stock buybacks

Related investing topics

FAQ

An (almost) tax-free way to return capital

Increase earnings per share

It's easier to cut buybacks in tough times