A graphic listing reasons to buyback shares of stock, including un-diluting the stock and increasing earnings per share.
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Over the past couple of decades, stock buybacks have become a big part of the way companies use their profits to return capital to shareholders. In the first quarter of 2022 alone, companies announced more than $300 billion in new repurchase authorizations, an all-time high. In 2021, repurchases totaled $880 billion just from companies on the S&P 500 index, and it’s estimated the total will exceed $1 trillion in 2022.

However, stock buybacks -- also known as share repurchases -- aren’t well-understood by many investors. Sure, the basic concept is simple: A company buys shares of its own stock. But the process behind it and the reasons why companies might choose to buy back their stock remain a mystery to many, as does the answer to whether stock buybacks are good for investors. In this article, we’ll dive into the basic knowledge investors need to know about stock buybacks and why it’s important to know how they work.

Understanding stock buybacks

Understanding stock buybacks

When a company has excess profits, or otherwise has accumulated cash on its balance sheet, there are a few different ways it can use the money. It can reinvest profits into the business by developing new products or increasing its inventory. It can acquire other businesses. It can pay a dividend to shareholders. And, it can use its cash to buy back shares of its own stock.

Many companies use some combination of these methods. For example, many stocks that pay dividends also buy back shares.

The mechanics of stock buybacks are usually quite simple. First, the buyback program is established. The company’s board will authorize the buyback, typically for a specific dollar amount with an expiration date. For example, you might read that “Company XYZ’s board of directors has approved a $500 million buyback authorization, beginning on July 1, 2022, and ending on June 30, 2023.”

To be clear, a buyback authorization doesn’t mean that the company will buy back any shares. In fact, buyback authorizations go unused quite frequently. But the authorization gives management the ability to do it.

Next, the company buys back shares. It typically does so on the open market, just like you and I would buy shares of a stock. In some cases, buybacks can be done directly from shareholders through a process known as a tender offer.

Finally, the repurchased shares are absorbed by the company, and the number of outstanding shares decreases.

Why do companies buy back their shares?

Why do companies buy back their shares?

At first it might sound odd that companies buy back shares of their own stock. But there are some solid reasons for doing so. Specifically:

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. 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 0.21%)(BRK.B 0.01%) stock buybacks.

In the midst of the 2022 stock market downturn, 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 believes the stock is a bargain relative to its intrinsic value.

An (almost) tax-free way to return capital

Unless you own shares of a stock in a tax-advantaged account such as an IRA, dividends are generally taxable. 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 contains 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. Some simple math shows that its earnings per share (EPS) for the year were $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

Let’s face it: There are fewer surefire ways to make a stock’s price go down than to cut a long-standing dividend. As a result, companies often don’t start or increase a dividend unless they’re fairly certain that the payout will be sustainable in the future.

On the other hand, buybacks come and go, and investors don’t really worry about it -- at least not to the extent that they worry about dividend cuts. So companies might choose to use profits for buybacks instead of committing to paying a dividend since it gives them more financial flexibility in the future.

Un-diluting the stock

Finally, another reason for buybacks is to offset dilution from stock-based compensation. If a company’s employees exercise options for say, 1 million new shares, it will dilute the stock. Over time, stock-based compensation can have a highly dilutive effect, but stock buybacks can be strategically used to keep the share count constant.

How stock buybacks affect the market

Stock buybacks don’t have any direct effect on the market, or on investors, aside from perhaps making dividends lower than they otherwise would have been.

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. And, although stock buybacks are technically just moving money from one place (a company’s balance sheet) to another, stock buybacks often have the effect of increasing 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 P/E ratio when valuing companies.

Pros and cons of stock buybacks

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, as well as 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:

(Chart by author.)
Pros of Stock Buybacks Potential Drawbacks of Stock Buybacks
Shareholder value can be created if stock is bought back for less than its intrinsic value. Many companies buy back stock just to boost earnings per share and sometimes overpay.
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.
More flexible way to return capital than paying dividends. They can use capital that could have been used in more productive ways (such as investing in new technological innovations).
Stock buybacks return capital to shareholders but aren’t taxable on the individual level as dividends are.

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. And, in many ways, buybacks have some significant advantages over paying dividends, especially if the stock is truly trading for less than its intrinsic value.

However, like most investing topics, there isn’t a one-size-fits-all answer to whether stock buybacks are good or bad for investors. They should be evaluated on a case-by-case basis.

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Stock Buyback FAQs

Are stock buybacks good for investors?

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It depends. When stock buybacks are used responsibly by boards of directors, 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. Additionally, buybacks can make a company’s earnings per share increase and can help offset dilution -- for example, through stock-based compensation to employees.

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. As an example, many companies tend to be flush with cash in strong economic environments, but their valuations tend to be high as well. 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?

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When a company buys back stock, it simply buys back shares on the open market, in much the same way as 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 it buys back 10,000, it will then have 990,000 outstanding shares of stock.

Do buybacks increase stock price?

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

Matthew Frankel, CFP® has positions in Berkshire Hathaway. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.