Stock buyback refers to the repurchasing of shares by a company.
Stock buyback refers to the repurchasing of shares by a company.
Stock Buybacks: An Efficient Capital Return Strategy
Stock buybacks have become increasingly popular among public companies as a way to give money back to investors. In fact, large U.S. companies have spent over $3.9 trillion in the last five years on stock repurchases, according to S&P 500 Dow Jones Indices. However, many people are still unsure about what exactly stock buybacks are and why companies choose this approach instead of paying dividends.
Unpacking Stock Buybacks
Stock buybacks, also known as share repurchases, are when a public company announces a program to buy back its own shares from the market. This is usually done by stating a specific amount of money that the company intends to spend on purchasing shares. Shareholders who are willing to sell their stock do so through market operations, usually unaware of who the buyer is or whether it is the company itself repurchasing its shares.
Companies generally do not announce the number of shares they plan to buy back, but rather provide a dollar amount. Take Wells Fargo (WFC), for example, they announced a $30 billion share repurchase program in mid-2023. This strategy allows companies to assess market conditions and determine whether the stock price is within their target range. Once the shares are bought, they are typically canceled, leading to a reduction in the total number of shares outstanding. At the end of the quarter, the company will announce the number of shares bought and the average price paid.
The Benefits of Stock Buybacks
Sterilization
One of the primary reasons for stock buybacks is sterilization, which involves canceling shares that would otherwise be issued to employees as part of stock options or restricted stock rewards. By repurchasing shares, the total number of shares remains unchanged, effectively sterilizing the normal growth in share count.
Leverage
Companies also engage in share buybacks to influence the stock price. This occurs through two mechanisms. Firstly, the buyback activity creates a natural buyer in the market, which helps keep the stock price elevated. Secondly, as the number of shares outstanding decreases, the calculation of earnings per share increases. Assuming the market applies the same price-to-earnings multiple, this leads to a rise in stock price over time.
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Efficient Return
A crucial reason for stock buybacks is the tax-efficient way they enable companies to return capital to investors. Instead of increasing dividend payments, companies can use the funds to buy back shares. As a result, the dividends per share increase without adding to the company’s dividend costs.
The comparison between companies that buy back shares and those that increase dividends reveals the greater after-tax return for buyback shareholders. Shareholders of buyback companies also enjoy a higher stock price since a reduction in shares outstanding exerts upward pressure on the stock price. The beauty of this approach lies in the fact that shareholders do not pay taxes on the unrealized gain from the increased stock price until they sell their shares. In turn, stock buyback programs efficiently return capital to shareholders by avoiding double taxation.
The Debate Around Stock Buybacks
While stock buybacks have their benefits, they are not without criticisms. As part of the Inflation Reduction Act of 2022, buybacks are now taxed at 1.0%. However, the Biden administration intends to increase this tax substantially. Their argument is that buybacks limit a company’s spending on initiatives that benefit all stakeholders, not just shareholders.
Nevertheless, this view is not shared by everyone. Warren Buffett, for instance, strongly disagrees with the criticism of buybacks. In his 2022 letter to Berkshire Hathaway (BRK.B) shareholders, he stated that those who detract from buybacks are either “economically illiterate or a silver-tongued demagogue (characters that are not mutually exclusive).”
Another criticism of buybacks is that they mainly benefit shareholders when prices are stable or falling. Some companies have been accused of buying back shares at market peaks, potentially overpaying for them. However, the majority of companies that engage in share repurchases have experienced favorable outcomes, with the stock price rising in tandem.
One interesting dynamic is that buybacks, given their popularity among investors, can have a leveraging effect. Companies often find themselves compelled to continue buying shares at increasingly higher prices, anticipating that prices will continue to rise.
Moreover, it is worth noting that almost all companies with significant buyback programs have positive free cash flow (FCF). This implies that all the money used for buybacks is essentially “free” after deducting expenses and capital expenditures from operating cash flow.
In conclusion, stock buybacks have emerged as an efficient strategy for returning capital to investors, minimising double taxation, and influencing stock prices positively. While criticisms exist, a wealth of evidence supports their benefits. As Warren Buffett himself recently confirmed, buybacks tend to work to the benefit of all shareholders.
