Pros and cons of stock buybacks

The short version:

• Stock buybacks are when a company repurchases some of their own shares which decreases the number of the shares that investors can buy and sell on the open market.
• By reducing the number of shares outstanding, companies are often able to increase their share price.
• However, the stock buyback strategy is not guaranteed to work in all circumstances and some investors may prefer for companies to use excess cash to pay dividends or reinvest in the business.

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What are stock buybacks?

When a company turns a profit, the cash can be allocated in one of four ways:

• Paid to shareholders as dividends.
• Kept for capital expenditures to expand operations for the future.
• Acquisition of other business entities, which can also increase future revenues.
• Used to initiate a stock buyback.

There are advantages and disadvantages to each of the four allocations. Dividends act as a reward to shareholders for holding the stock. And investments in either capital expenditures or acquisition of other business entities can increase future revenues.

But stock buybacks are often chosen because they have the potential to increase share price — often immediately.

For example, let’s say a company has a total market capitalization of $100 billion with one billion shares of stock outstanding. That gives each outstanding share a value of $100.

But the company decides to do a stock buyback. The decision is made to repurchase 10% of the outstanding stock, or 100 million shares.

Now the $100 billion in market capitalization is divided by just 900 million shares, not 100 million. In theory at least, that should increase the share price from $100 to a little over $111.

All things being equal, the earnings per share (EPS) of the stock should also increase. If the company has a profit of $100 billion, its EPS is $100 with one billion shares outstanding. But by reducing the number of shares to 900 million with the stock buyback, EPS jumps to $111.

That’s the kind of valuation increase investors have come to love.

Why do companies do stock buybacks?

There are many reasons that a company may have for buying back their own stocks.

Driving up a stock’s value

The most obvious benefit of stock buybacks is an increase in the company’s share price. For example, they may buy back shares if they believe the stock to be undervalued. By reducing the number of shares outstanding, it may be possible to drive the price to what they consider to be a more reasonable value.

It may also be possible for a company to use stock buybacks to support the share price. If the price has declined in recent months, the company can often establish a floor under its value through a single stock buyback, or even a series of buybacks.

Investing with lower stakes

Stock buybacks are also seen by company insiders as a lower-risk way to invest profits. For example, investing in capital expenditures or acquisitions have the risk of failure. Though there is the risk a stock buyback can backfire, it’s more likely that the outcome will be positive.

And as mentioned, the results are more immediate. Investments in new ventures can take years to produce positive results. Stock buybacks can literally increase the share price in a matter of days.

Benefitting company insiders

It also should not be overlooked that company insiders – directors and upper management – are usually the largest shareholders in a publicly-traded company. Anything that increases the share price is likely to have a direct benefit to those insiders.

For example, payment of performance bonuses to upper-level employees is often contingent on stock price performance. As well, many insiders also have stock options. The higher the value of the stock, the more valuable the options will be.

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Stock buybacks vs. dividends

While capital expenditures and acquisitions are long-term investments that may not pay off for years, both stock buybacks and dividends can provide immediate rewards to shareholders.

But which is the better of the two from a shareholder standpoint?

Much will depend on each shareholder’s reason for holding the stock. Some people invest for income. For those investors, dividends are preferred. But others who invest for price appreciation will be better served by stock buybacks.

For the income crowd, stock buybacks may hold little benefit. If the primary reason for investing in the stock is dividend income, the increase in share price doesn’t translate into additional cash flow. That benefit takes place only if the shareholder sells their stock.

But for the long-term investor, whose primary interest is capital appreciation, stock buybacks can be an important part of the equation. This is especially true if a company regularly engages in buybacks. If the market comes to anticipate periodic buybacks, there may be greater public interest in the stock.

Benefits of stock buybacks

We’ve already discussed the reasons why companies do stock buybacks. But what are the specific benefits of stock buybacks to individual investors?

Let’s look at four benefits of particular interest to shareholders.

Usually results in a higher stock price

As much as anything else, the main purpose and benefit of a stock buyback for investors is to increase the stock price. That provides an instant windfall for shareholders of the company, in addition to company insiders.

What’s more, it happens without any action taken by the investors themselves. The stock becomes instantly more valuable because the company has reduced the number of shares outstanding.

A stock buyback can also create momentum that causes the share price to rise even further — especially if the company shows a pattern of undertaking periodic buybacks. Other investors might be tempted to buy shares if they believe they can count on management to consistently reduce the number of shares outstanding.

Increases earnings per share (EPS)

This is a major reason why stock buybacks typically result in higher share prices. With the buyback, and a reduction in the number of shares outstanding, the earnings-per-share (EPS) also immediately increase. If the company buys back 10% of the outstanding stock, EPS will increase by approximately 10% as well.

Gives investors an opportunity to exit the stock

With the increase in price that usually comes with stock buybacks, investors have an opportunity to sell their shares at a more advantageous price.

For example, let’s say an investor bought company stock at $90 per share. But the stock price has been languishing since the investor bought it. The company does a stock buyback, and the price instantly rises to $100. The investor now has an opportunity to sell his or her position at a profit of $10 per share. It may create a perfect opportunity for that investor to exit the stock.

Lower tax consequences than dividends

While dividends can create a tax liability, share price increases from buybacks will get the benefit of long-term capital gains upon sale. That is, if the stock is held for more than one year. That’s because the IRS provides generous tax breaks for holding investments on a long-term basis.

A married couple filing jointly with $75,000 in taxable income will likely pay zero additional tax on the gains from stock held more than one year.

Of course, that benefit goes only to long-term investors. For short-term traders, trading outside a tax-sheltered retirement plan, short-term gains are subject to ordinary income tax rates.

More: Taxes and investing: What first-time investors need to know about filing taxes

Drawbacks of stock buybacks

Despite the potential to provide an immediate increase in share price, stock buybacks do have their drawbacks.

Increased EPS isn't due to actual earnings growth

First and foremost, stock buybacks increase the earnings per share without a corresponding increase in company earnings. The increase in EPS is simply a product of dividing a fixed amount of earnings by a reduced number of shares. Meanwhile, the increased EPS will mask the reality that earnings are not growing.

Stock buybacks may hurt long-term prospects

By using profits to buy back company shares, the company is not investing in the future of the business. Stock buybacks are purely a play on increasing the share price.

If a company dedicates an excess amount of profits to stock buybacks, it may impair the long-term prospects of the business. While they’re busy buying back their own stock, they’re not purchasing new income-generating assets or business entities that may actually help the organization.

Stock buybacks help insiders more than stockholders

Stock buybacks can have the greatest potential to benefit company insiders. Since bonuses and stock options are tied to share price, implementing stock buybacks may be more about enriching insiders than benefiting general stockholders.

Major stock buybacks in 2022

Stock buyouts don’t always produce the desired outcome, especially in the face of a declining market.

The share price can return to equilibrium shortly after a buyback. After all, the basic financial strength of the company has not improved. Reducing the number of outstanding shares may serve only to temporarily mask this reality.

Sample of 10 major stock buybacks that have taken place during the first seven months of 2022

Notice from the table that only three of the 10 companies doing buybacks have experienced an increase in share price since the buyback date. One of the three, Twitter, may have seen their share price increase primarily because of the purchase offer by Elon Musk, though we can’t know for sure.

More: What are FAANG stocks?

It’s clear from this table that even stock buybacks are subject to major movements in the market. Given that the market is down 13.34% year to date – as measured by the S&P 500 index – it’s not surprising that seven of the 10 companies have seen share price declines. Still, it’s not unreasonable to conclude that the buybacks likely prevented even greater declines.

Bottom line

Though stock buybacks are widely seen as a positive development for shareholders, the reality is not universally true. They can be beneficial as long as they are done by companies with a strong history of revenue and earnings growth.

But if buybacks are done primarily to juice the share price, the long-term effect can be neutral at best, and negative at worst. After all, the company is using its profits primarily to pump up its share price and not to grow its future cash flow.

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