Successful companiesoften reach a point when they generate more cash than they can reasonably reinvest in the business. As an investor, you want to see that excess come back to you, and there are a few ways companies can do that.
Traditionally, dividends were the go-to method. Companies would take a part of their profits and distribute them directly to shareholders, usually quarterly. It's a straightforward way to reward investors for their support, and there wasn't the alternative of stock repurchases, which were banned by the U.S. Securities and Exchange Commission (SEC) until 1982 (they were considered attempts at market manipulation).
Once allowed, companies have often returned more to shareholders through stock buybacks than dividends, seeing them as having more flexibility and certain tax advantages. The proportion of companies that paid dividends in 1980 was 78%. By the late 2010s, the figure was half that. Every year from 1997 to 2023, the value of stock buybacks for S&P 500 firms outpaced dividends. In the 1980s, the dividend yield for the S&P 500 was typically between 3.5% to 5.5%. It last exceeded 2.0% in 2015.
As stock buybacks have increased in popularity, they have also gotten far more attention from the nonfinancial press. After major corporate tax cuts in 2017, critics charged that companies weren't using the extra returns to hire more workers and expand, as proponents argued they would, but were simply funneling the cuts back to investors through buybacks. In 2022, the Inflation Reduction Act introduced a 1% excise tax on share repurchases of over $1 million, causing a drop the following year in share repurchases, though they came roaring back in 2024. As we've reported, that includes Apple Inc.'s (AAPL) May 2024 announcement of a record-setting stock $110 billion stock repurchase program.
Given their popularity among corporate boards, are buybacks good for investors? Below, we discuss the four major reasons investors like buybacks.
Key Takeaways
- A stock repurchase, or buyback, is when a company buys some of its own shares in the open market and retires them.
- Buybacks tend to boost share prices in the short-term, as they reduce the supply of outstanding shares and the buying itself bids the share higher in the market.
- Shareholders typically view buybacks as a signal of corporate health and optimism from company managers that their shares are undervalued.
- When buybacks rise for U.S. companies overall, this is seen as confidence in the American economy going forward.
- 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
Here's how share repurchases work: instead of paying out cash dividends, a company uses its excess funds to buy back its own stock from the market. This reduces the number of outstanding shares, which should drive up the value of the remaining shares. In essence, buybacks are a way for companies to invest in themselves while putting money into shareholders' pockets (through the increased share price and the slight reduction, by percentage, of future dividends paid to those stocks).
When a company like Apple announces a large stock buyback program, it doesn't go out that day to execute the entire buyback all at once. Instead, the buyback is usually carried out over an extended period—this is the flexibility companies like—which can range from several months to a few years, depending on the size of the buyback and the company's strategy. Typically, buybacks are carried out on the open market, similar to how investors purchase stocks.
Investors can choose whether to take part in the repurchase program. One option is to defer taxes and turn their shares into future gains by not participating. Buybacks benefit investors by increasing share prices, which is more tax-efficient.
1. Improved Shareholder Value
There are many ways to measure the success of their stocks. However, the most common is earnings per share (EPS). This is typically viewed as the most important variable in determining share prices. It's the portion of a company’s profit allocated to each outstanding share of common stock.
When companies buy back shares, they 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 necessarily increase.
Let's say, for example, that a company has 1 million outstanding shares and earns $1 million in profits. Its EPS would be $1 per share. If the company buys back 100,000 shares, reducing outstanding shares to 900,000, its EPS would increase to $1.11 per share ($1 million in profits divided by 900,000 shares).
Shareholders who don't sell now have a higher percentage of ownership of the company’s shares and a higher price per share. Those who sell have done so at a price they were willing to sell at.
2. Boost in Share Prices
When a company thinks its shares are undervalued, it may buy back them from the market. This strategy can significantly impact the stock price and the company's overall value.
Companies repurchase shares and then resell them in the open market once the price increases to accurately reflect the company's value. As the EPS increases, investors are more likely to buy the stocks, driving up the price.
Of course, share buybacks are not guaranteed to increase a stock price. If a company overpays for its shares or uses debt to finance the buyback, it could end up hurting its financial position in the long run. The gains may be short-lived if the company's fundamentals don't support the higher stock price.
3. Tax Benefits
When excess cash is used to repurchase company stock, instead of increasing dividend payments, shareholders have the chance to defer capital gains if share prices rise. Traditionally, buybacks are taxed at a capital gains tax rate, while dividends are subject to ordinary income tax. If the stock has been held for over a year, the gains would be subject to a lower capital gains rate.
If you sell the stock back to the company, you'll have to pay the capital gains tax on any profits you make. However, if you've held the stock for more than a year, you'll qualify for the long-term capital gains rate, usually lower than the ordinary income tax rate.
For example, let's say you bought 100 shares of a company at $50 per share, and the company later announces a buyback program at $60 per share. If you sell your shares back to the company, you'll have a capital gain of $1,000 (100 shares x $10 profit per share). If you've held the stock for over a year and fall into the 15% long-term capital gains tax bracket, you'll owe $150 in taxes on that gain.
Now, let's compare that to dividends. If the company had instead chosen to pay out that $1,000 as a dividend, you'd be subject to ordinary income tax on the total amount. Depending on your tax bracket, that could mean paying a higher rate than the capital gains tax. As always, it's prudent to consult with a tax professional or financial advisor to determine the best strategy for your situation.
The Inflation Reduction Act of 2022 put a 1% excise tax on the share buybacks of U.S. companies.
4. Excess Cash Is a Sign of Confidence
When companies buy back stock, they demonstrate to investors that they have additional cash on hand. If a company has excess cash, then 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 reinvesting them in alternative assets. In essence, this supports the stock price and provides long-term security for investors.
Apple's Record $110 Billion Buyback
In May 2024, Apple announced the largest stock buyback plan in U.S. history, authorizing an additional $110 billion in share repurchases. This surpasses the company's own record, set in 2018 when it authorized $100 billion in buybacks.
Pros and Cons of Stock Buybacks
Pros
Increases EPS by reducing outstanding shares
Boosts stock prices, benefiting shareholders
Provides a tax-efficient way to return cash to shareholders compared with dividends
Demonstrates confidence in the company's prospects
Helps offset dilution from employee stock options and grants
Cons
May signal a lack of productive investment opportunities
Can be viewed as a form of market manipulation
May prioritize short-term gains over long-term growth
Can lead to excess leverage if funded by debt
May divert funds from R&D, capital expenditures, or acquisitions
The Downside of Buybacks
While investors tend to like buybacks, they do have disadvantages. Buybacks can be a signal of the market topping out, and some companies repurchase stocks to artificially boost share prices. Share buybacks could indicate that a company has little use for its cash in terms of new investment opportunities, projects, or research and development (R&D). And, if the buyback is financed with debt, it can overleverage certain companies.
Typically, part of executive compensation is tied to earnings metrics, and if earnings can't be increased, buybacks can artificially do the trick. Also, when buybacks are announced, any share price increase will typically benefit short-term investors more than investors seeking long-term value. This creates a false signal to the market that earnings are improving due to organic growth and ultimately could hurt a company's value.
What Are the Alternatives to Share Repurchases?
Instead of share buybacks, companies might invest in growth opportunities such as , expanding operations, or acquiring other businesses. Alternatively, they could increase dividends. The choice depends on the company’s strategy and market conditions. For instance, if a company sees greater potential for growth or innovative projects with great returns, investing in these prospects could yield better long-term benefits than a buyback. Similarly, increasing dividends might be preferable if the company wants to attract income-focused investors.
Do You Have To Sell Your Shares in a Buyback?
No, a company can't force you to do so. Firms, however, typically offer a premium for the shares to entice shareholders to sell their shares back to the company.
Are Share Buybacks Regulated?
The SEC regulates share them primarily through its Rule 10b-18, which minimizes the potential for market manipulation, mostly from companies artificially inflating their share prices. For instance, companies must use a single broker or dealer each day when executing buyback trades and are restricted to buying shares at specific times during the trading session to avoid influencing the closing price. There's also a limit (25% of the previous four weeks' trading volume) on the number of shares purchased daily.
In recent years, the SEC has sought to bring more transparency to companies engaged in repurchases. However, the U.S. Court of Appeals for the Fifth Circuit struck down an initial 2023 rule that would have required companies to report quarterly or semiannually daily figures for their buybacks (along with any executives engaged in trading the company's shares). The rules were in place for the latter half of 2023, but following the court's ruling, it was rescinded.
The Bottom Line
Generally, investors view stock buyback programs positively. A company can return funds to investors through dividends, retained earnings, and the popular buyback strategy. Buybacks can boost shareholder value and share prices while also creating tax advantages. While buybacks can signal a firm's financial stability, a company’s fundamentals and historical track record are more important when determining its potential for long-term value.
