4 Reasons Investors Like Buybacks

Buybacks have become a popular way for a company to return value to shareholders, similar to a dividend. Instead of returning profits to shareholders in a quarterly check, the company buys its own shares on the open market, increasing its stock price.

Although they attract frequent criticism, many companies prefer to spend their earnings on buybacks rather than dividends. Every year from 1997 to 2023, the value of stock buybacks for S&P 500 firms outpaced the value of dividends. In the 1980s, the dividend yield for the S&P 500 was typically between 3.5% and 5.5%. The last time it exceeded 2.0% was in 2015.

Given their popularity among corporate boards, are buybacks good for investors? Below, we discuss the four major reasons investors like buybacks.

Understanding 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, driving 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 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. Instead, the buyback is usually carried out over an extended period, ranging 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 than receiving a dividend.

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.

Suppose 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 them back 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.

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 it in alternative assets. In essence, this supports the stock price and provides long-term security for investors.

Advantages and Disadvantages of Buybacks

Buybacks allow companies to raise their share value and increase their earnings per share, a key metric for the value of a company. This can improve investor confidence and signal that the company believes that its shares are undervalued. Buybacks also offer a way to return value to shareholders at a lower tax rate than dividends.

But 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.

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.