What are Stock Buybacks?

Public companies that operate profitably may be capable of returning cash to shareholders through a process called stock buybacks. Stock buybacks are when a public company uses cash to buy shares of its own stock, thus reducing the number of shares outstanding.

A company can implement stock buybacks using several methods, including open market stock repurchases and fixed-price tender. Generally, stock buybacks are instituted to boost the company’s stock price, improve financial ratios, and offset ownership dilution.

While dividend payments have been the dominant form of returning capital to shareholders, there has been a shift to stock buybacks in hopes of benefiting from increased tax efficiency and financial flexibility.

Stock buyback methods include open market repurchases, fixed-price tender, Dutch auction, and accelerated share repurchases.

Since the early 1990s, open market repurchases have been the most used method to execute stock buybacks. This is due in part to the enactment of Rule 10b-18, which provided firms with a safe harbor to buy back shares of their common stock.

With open market repurchases, the firm is not obligated to buy back any shares, making this method flexible and cost-effective as the company purchases shares at the current market price.

A company can also implement a fixed-price tender which entails making an offer to shareholders that includes the fixed price and date of the repurchase. Usually, a fixed-price tender will purchase shares at a premium but can be completed quicker than open market repurchases.

Similarly, with a Dutch auction, a company makes an offer to shareholders that includes a range of prices. Shareholders submit their bids by specifying the number of shares and the minimum price at which they are willing to sell. A company then reviews the bids and determines the suitable price to complete the buyback.

Lastly, the accelerated share repurchases method requires the assistance of an investment bank to complete the buyback. A company initiates this transaction by lending money to a bank which will then use the funds to borrow large blocks of shares from institutional investors.

The bank will then deliver the borrowed shares to the company and subsequently buy more shares on the open market to return the borrowed shares to the original owners.

Companies often engage in this program when they believe their stock price is undervalued or if they are seeking to quickly complete the transaction.

Generally, stock buybacks are implemented to increase the company’s share price. If the board of directors views its stock price as undervalued, the company can use stock buybacks to acquire outstanding shares.

Because stock buybacks use cash to reduce the number of shares outstanding, they can impact key metrics like earnings per share (“EPS”).

For example, when dividing a company’s net profit by a lower number of shares, the result is a higher EPS. Public market investors pay close attention to this metric as it is the denominator in the price-to-earnings multiple.

While companies have several options for rewarding shareholders, stock buybacks provide management with greater flexibility than dividends. Once a company institutes dividends, it is likely to remain under pressure to continue such payments.

Conversely, stock buybacks give companies more control as they are not obligated to fulfill the announced authorization.

Stock buybacks are also tax-efficient in that shareholders who sell their shares back may incur a tax liability, but the remaining shareholders are rewarded with increased equity ownership and no additional taxes.

In addition, capital gains are subject to more favorable tax treatment. Despite the favorable tax rate, stock buybacks offer added flexibility because investors can defer taxes and sell shares to create homemade dividends when necessary.

Stock buybacks can even allow companies to offset the equity dilution that takes place when companies use stock options to compensate employees.

The more shares a company issues, the greater the ownership dilution that takes place. Stock buybacks help offset this dilution by decreasing the shares outstanding and increasing the ownership value of the remaining shares.

Many critics of stock buybacks call them an unproductive and inefficient way to create value for shareholders. In some cases, stock buybacks focus too much on short-term gains at the expense of generating long-term value.

Depending on company-specific factors, using cash to buy back shares may not be a productive use of a company’s balance sheet.

Most companies need to continually invest in research and development to succeed in the long run, and a stock buyback might give investors the impression that the company has few growth levers remaining.

Frequently, companies will also use debt to repurchase shares. Low-interest rate environments tend to encourage this behavior, lending some companies to weaken their financial position to financially engineer a higher stock price.

Oftentimes, stock buybacks are also used to conceal excessive stock-based compensation granted to employees. This practice dilutes existing shareholders, making stock buybacks an effective tool to offset this dilution.

Moreover, starting January 2023, stock buybacks are subject to a 1% excise tax under specific conditions, effectively making share repurchases more expensive to implement.

Historically, dividend payments have been the dominant form of returning capital to shareholders. However, there has been a shift to stock buybacks in hopes of benefiting from an increased tax efficiency and financial flexibility.

Typically, stock buybacks are instituted to boost the company’s stock price, improve financial ratios, and offset ownership dilution.

However, there may be drawbacks to stock buybacks, including a heightened focus on short-term goals, foregoing growth opportunities, and concealing excessive stock-based compensation.

Sources:
Forbes Advisor, June 2022. "What is a Stock Buyback?
S&P Dow Jones Indices, March 2020. "Examining Share Repurchases and the S&P Buyback Indices in the U.S. Market."
Finbold. "What is a Stock Buyback? Definition & Benefits of Share Repurchases."
Real Vision, September 2022. "What is a Stock Buyback?"
smartasset, May 2022. "How Stock Buybacks Work and Why Companies Do Them."
Investopedia, August 2022. "Stock Buybacks: Why Do Companies Buy Back Shares?"
Corporate Finance Institute. "Stock Buyback Methods."
Wikipedia. "Share repurchase."
Wikipedia, September 2022. "Accelerated Share Repurchase."