You might buy more of it in anticipation of future growth. Corporate executives do the same thing. When a company buys more of its stock after determining it's undervalued, it's known as a corporate buyback, reducing the number of outstanding shares, increasing the gains for investors per share.
As an investor, you should work to understand buybacks and how you can put them to work for you.
So, what is a buyback in the stock market? This article will explore the benefits of buying back stocks and "How do stock buybacks work?" We'll also discuss why companies do it and some major criticisms. But first, let's get to grips with the definition of a buyback.
What is a stock buyback?
A stock buyback is when a company repurchases its shares in the marketplace. It reduces the number of outstanding shares available and will increase the company's earnings per share. When earnings increase, the stock price rises as more investors become enthusiastic about the stock.
So, what is a buyback in stocks? Looking at it another way, one of the simplest definitions of a company's purpose is to provide value to its shareholders. After all, each share of a company represents an ownership stake in that company. One of the most tangible ways publicly traded companies can provide value to shareholders is by returning capital to them.
Of course, one of the most common ways companies do this is by issuing dividends. This takes a percentage of a company's earnings and returns them to their shareholders. A stock buyback is just another way to accomplish this.
What is a stock buyback program, then?
Stock buybacks in any form are an important part of corporate finance. Through executing stock buyback programs, companies can help increase returns for their shareholders while improving the overall value of their shares. Companies have different methods and strategies for initiating a stock repurchase program. In general, there are two main ways.
Direct repurchase from shareholders
In this scenario, a company will tender an offer to shareholders that specifies how many shares the company is looking to repurchase and a price range that the company will pay for those shares. This price range is typically above the stock's current market price. Shareholders will respond to the tender by indicating how many shares they are willing to sell and the price they will accept for those shares. Once the company receives all its offers, it will execute the common stock repurchase at the lowest cost.
Buy back shares on the open market
In this scenario, the company simply buys its shares on the open market as if it were a retail investor. However, once a company announces that it is planning to buy back shares, its stock price tends to rise, which means it may have to pay more than it was planning to execute the buyback. It has been the most popular kind used by companies recently due to recent regulation changes that allow these purchases without prior disclosure or shareholder approval
There are also tender offers and Dutch auctions for buybacks, which involve a more targeted approach to buying back shares from specific shareholders, which we'll discuss below.
Now that we have a better understanding of a buyback, let's look at some examples of companies from different sectors that have undertaken stock buybacks and their motivations.
For starters, tech giants like Apple Inc. (NASDAQ: AAPL) and Microsoft Corporation (NASDAQ: MSFT) are perhaps the most visible when deploying corporate share repurchases in recent years.
In this case, they used the strategy to increase earnings per share by reducing outstanding shares on the market while providing an additional outlet for cash flow management (as many investors who don't want dividends prefer). Other technology heavyweights such as Alphabet Inc. (NASDAQ: GOOG), Intel Corporation (NASDAQ: INTC), Oracle Co. (NASDAQ: ORCL) and International Business Machines Corp. (NYSE: IBM) have also used stock buybacks as a way to return capital to shareholders while increasing their earnings per share.
But it's not just tech companies that have used buybacks. Retail behemoths Walmart Inc. (NYSE: WMT) and Target Co. (NYSE: TGT) have launched share repurchase programs, with Walmart spending over $67 billion on buybacks between 2008 and 2018.
The company saw the benefits of reducing its outstanding shares, which led to increasing dividends paid per share and higher earnings per share, which contributed to the company's overall growth.
In the oil and gas sector, ExxonMobil Corporation (NYSE: XOM) has used buybacks to return capital to shareholders rather than issuing dividends, which can be volatile depending on oil prices. The finance sector also plays host to this phenomenon. JPMorgan Chase & Co (NYSE: JPM) has bought back billions of dollars of its shares to boost earnings per share and return capital to its shareholders.
Mechanisms and impact of stock buybacks
Stock buyback meaning is a way to return cash to shareholders without having them pay taxes on dividends. Through stock buybacks, companies can reduce their number of outstanding shares on the market, increasing earnings per share and returns on capital. The main mechanisms executing such programs are open-market purchases (OMP), tender offers and Dutch auctions (TODA).
Open market purchases
These involve buying back stocks immediately when they hit certain prices or reach a certain financial metric during regular market trading hours. It occurs through brokerage firms who work with the issuing company directly to execute these repurchases quickly but not at the expense of driving up the stock price. The goal is to execute these purchases at a lower price than the company believes the stock is worth.
Tender offers and Dutch auctions
Tender offers and Dutch auctions are more targeted approaches to executing stock buybacks. In a tender offer, the company publicly announces that it's willing to buy back shares from its shareholders for a specified price. Shareholders interested in selling their shares then can indicate how many shares they are willing to sell and at what price, with the company purchasing shares at or below the predetermined price.
Dutch auctions, on the other hand, involve setting a range of prices at which the company is willing to buy back shares and allowing shareholders to say how many shares they're willing to sell at any given price within that range. The company then purchases shares starting at the highest price and working its way down until it reaches the number of shares it wants.
Reasons for stock buybacks
That said, why would a company buy back stock? And what is a corporate stock buyback? Essentially, unused cash can drag a company's balance sheet. For that reason, a company may choose to repurchase its shares for several reasons.
The best use of capital at the time
It's expensive for a company to have a large amount of excess cash sitting on the sidelines. On occasion, a company will choose to use excess cash to reinvest in its business or even to participate in arbitrage (growth through acquisition). However, in recent years, it's become widely accepted for a company to announce a share buyback to liquidate some excess capital.
Increase share price to counter an unfair valuation
Traders frequently trade on the news. Sometimes, when a company goes through a few rough news cycles, its stock can experience a sharp selloff. At times like this, a stock buyback can be seen as a company betting on itself because a company's stock price will tend to rise upon the announcement that it's participating in a share repurchase.
Improve company metrics
As mentioned above, a stock buyback has some predictable effects on a company's bottom line by increasing its earnings per share and decreasing the book value per share. However, when a company announces a buyback, investors and traders view this as a sign that the company is healthy and will “bid up” the stock, elevating the stock’s valuation, raise its price-to-earnings ratio (P/E ratio) and its return on equity (ROE) will increase.
Overcome dilution from employee stock options
To attract top talent, many companies make stock options an integral part of a compensation package. When these options are exercised, it increases the number of outstanding shares in the market, which can negatively affect a company’s balance sheet. Stock buybacks are a way to mitigate those effects.
Evaluating stock buybacks as an investment
Ultimately, investors only see a net benefit of a stock buyback if the company is correct in purchasing stock back at a lower intrinsic value than its future value.
With that in mind, here are three ways that investors may benefit from stock buybacks:
- Their remaining shares generally increase in value: When a company issues a stock buyback, their earnings per share increase, but a stock buyback typically has the effect of causing a company's price per share to rise. While the shareholder may own fewer shares, the shares they continue to own should increase in value.
- They own a bigger share of the company: Because there are fewer outstanding shares, and each share represents a piece of ownership, each investor's remaining shares give them a larger ownership stake.
- They can realize a tax advantage: Stock buybacks and dividends are taxed at different rates. Dividends are taxed at the ordinary tax rate for the individual. In contrast, buybacks are taxed at a lower capital gains tax rate. Furthermore, investors can defer capital gains if share prices increase.
After learning all that, maybe you're evaluating a stock or the performance of a company's buyback program. If so, there are several key financial ratios and metrics to consider. These include:
Return on invested capital (ROIC)
This metric measures how efficiently a company uses its capital to generate profits. A high ROIC indicates that a company is making effective use of capital and can be a sign of financial health.
Price-to-earnings ratio (P/E ratio)
The P/E ratio compares a company's current stock price to its earnings per share (EPS). A higher P/E ratio suggests that investors value the company’s stock more. Companies with buyback programs tend to have higher P/E ratios than those without.
Free cash flow
This metric measures how much cash a company has left after paying all expenses and taxes. Companies with strong free cash flow can better fund buybacks and other investments, which can positively impact stock prices.
Incorporating buyback analysis into your investment strategy
When done properly, stock buybacks can be an effective tool, but do your homework when evaluating companies with buyback programs. Here are some tips for incorporating buyback analysis into your investment strategy:
- Look for companies with strong fundamentals: A company's fundamentals should be sound before investing in it, whether or not it has a buyback program. Ensure you thoroughly evaluate earnings, sales growth, profit margins and other key financial metrics before buying a stock.
- Consider the long-term implications: Don't just focus on the immediate boost in stock price that a buyback may provide. Instead, consider the long-term implications of the buyback program. Is the company investing in growth opportunities or using the buyback as a short-term solution to boost its stock price?
- Take note of company insider behavior: If insiders sell their shares or executive compensation is tied to stock buybacks, this may be a warning sign that the company is more focused on short-term gains than long-term success.
- Look at the company's debt level: If a company is heavily indebted, it may not be able to fund a buyback program. Make sure you evaluate the company's debt level and ability to service its debt before investing in a buyback program.
How stock buybacks impact investors
The direct and indirect effects of stock buybacks on shareholders can vary. Stock buybacks reduce the number of outstanding shares, which increases the ownership percentage for any given investor. It can increase market value since fewer available stocks signify higher demand, hence a higher price.
Dividend policies may also change due to the reduced amount of issuing capital stock emitting dividends, which means greater payments for investors left with a bigger stake.
For example, in 2019, Microsoft announced its intention to invest $40 billion in stock buybacks, one of the largest amounts in the company's history. It wasn't the first time Microsoft had allocated major funding for stock purchases on the open market.
Before that, Microsoft had twice authorized $40 billion repurchases in 2013 and 2016. Microsoft pushed it even higher by taking millions of shares off the market when their stock increased in value. By September 2021, the share buyback programs helped Microsoft's stock price more than double, from $130.90 to $301.76, since it announced the last such program.
Stock buybacks have led to improved earnings per share and return on equity. However, stock buybacks aren't necessarily a guarantee of long-term success, and they're increasingly under fire from critics.
Risks, controversies and regulatory considerations
Stock buybacks were once illegal. That only changed in the 1980s. But in the last 15 years or so, stock buybacks have become standard operating procedure for many top companies — even some of the most venerable blue chips. Still, stock buybacks get criticized for several reasons.
Some argue that if a company has excess cash, it should use it for social good, like raising wages for existing workers, investing in research and development or increasing capital expenditures.
The idea that a company might be accountable to its employees as much as, or at least in proportion to, its shareholders is more of a philosophical debate. A more fundamental concern is that stock buybacks may be too short-sighted. By putting too much emphasis on the next quarter or six months, a company may be undervaluing its cash on hand and issuing stock buybacks that are too large, which can hurt shareholders and even the broader economy.
A third concern economists have about stock buybacks is that because repurchasing stock can positively affect a company’s balance sheet, a company may use a buyback to cover up more serious issues. For example, it's a fairly common practice for companies to borrow money to execute their share buybacks. But if that borrowed money is replacing actual cash, it can reflect that a company is using a buyback to paper over deeper problems.
Finally, many economists worry about the effects of large buybacks on income inequality. Some argue that when companies distribute more money to shareholders through buybacks, they're distributing more capital to people who tend to be higher up on the economic ladder already.
In response to these criticisms, the Securities and Exchange Commission has declared that companies must disclose all security purchases at least once a quarter. However, they can update this rundown more often if needed.
The SEC also requires that companies provide annual reports detailing any repurchases they made during the fiscal year. These reports must include information on how much the company spent on repurchasing shares and a breakdown of which kinds of shareholders benefited most from those transactions.
These include pension fund investors buying through mutual funds or company insiders, such as internal directors’ purchases or sales. Finally, companies must disclose any insider trading during a buyback program because it can indicate improper use of information.
Because of these risks and concerns, there's now greater scrutiny from regulators worldwide regarding how much companies can invest in share repurchases. Some jurisdictions, such as France, have proposed or even implemented regulations restricting a company's ability to engage in corporate debt-financed stock buybacks. Some lawmakers have proposed similar legislation in the U.S.
Market trends and case studies
Despite the risks and controversies, stock buybacks are an ever-popular tool for companies to reward shareholders. Repurchasing shares has become increasingly common as publicly traded companies race to increase their share price and boost value.
U.S.-listed stocks have seen record-setting levels of repurchase activity recently, with billions being spent on these transactions each quarter.
For an example of how stock buybacks can impact investors directly, let's look at Microsoft's 2019 fiscal year. It announced plans to return as much as $40 billion to shareholders through stock buybacks and dividends.
Microsoft's buyback program reduced the number of outstanding shares, which boosted the company's earnings per share and increased demand for the remaining shares, causing the stock price to rise. It directly benefited investors who held onto their shares, as they saw their ownership percentage increase to the total number of outstanding shares.
However, some investors also criticized Microsoft's heavy reliance on stock buybacks, saying the company should have invested more in research and development or paid its employees higher salaries. It raises the large question of whether a company's social responsibility should come before shareholder value, and whether short-term gains from buybacks are worth sacrificing long-term investment.
You can see another case study of the impact of stock buybacks with Apple. In 2018, the tech giant announced a $100 billion share repurchase program, one of the largest in corporate history.
Some praised this move since it helped to boost the company's stock price and earnings per share. However, others criticized the decision to use the company's extra cash to reward shareholders instead of relieving income equality or investing it back into the business, indicating that the debate over share buybacks is a heated one that nobody can settle anytime soon.
On a macroeconomic level, low interest rates or a prosperous stock market can encourage companies to pursue buyback programs. Low interest rates make it cheaper for companies to borrow funds and repurchase shares. When the stock market is doing well and stocks are trading at high prices, investors tend to expect more ROI, which leads to many publicly traded companies trying buybacks.
Buying the hype about buybacks
Still wondering, "What is a buyback program in stock?" As long as you understand their many nuances, risks and rewards, stock buybacks can be a powerful tool to maximize your returns.
If you have the time and energy, analyzing macroeconomic conditions and company-specific data can help you understand how repurchase programs might affect your portfolio over the long term. You can more confidently choose stocks by understanding the opportunities and pitfalls.
