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How Stock Buybacks Work

Matthew Frankel, CFP, The Motley Fool

Dividends are the more well-known way that companies return capital to shareholders, but stock buybacks are equally important to understand. Buybacks are a large part of the profit-allocation strategies of many publicly traded companies. Here's a rundown of how stock buybacks work, why companies may choose to buy back shares, and the other important things to know about stock buybacks and what they mean to you as an investor.

What is a stock buyback?

Suppose a publicly traded wants to return some of its profits to investors. Instead of giving them cash, a company can choose to buy back shares of its own stock, effectively taking them out of circulation.

There are two main ways companies can choose to share some of its profits to investors. The most familiar method of distributing profits to investors is through dividends. However, stock buybacks can be just as important, if not even more so, for investors. 

Two businessmen looking at financial data on computer screens.

Image source: Getty Images.

To be perfectly clear, buybacks and dividends aren't an either-or scenario. Companies can choose to do some combination of both buybacks and dividends, and many do exactly that. As one example, Wells Fargo returned a total of $25.8 billion of capital to shareholders in 2018. $17.9 billion of this was in the form of stock buybacks thanks to a huge buyback authorization currently in effect, while the other $7.9 billion was paid directly to investors as dividends.

Why do companies buy back stock?

Here are a few of the most common reasons companies may choose to buy back stock, followed by a brief explanation of each:

  • Limited potential to reinvest for growth.
  • Management feels the stock is undervalued.
  • Buybacks can make earnings and growth look stronger.
  • Buybacks are easier to cut during tough times.
  • Buybacks can be more tax-friendly for investors.
  • Buybacks can help offset stock-based compensation.

Limited potential to reinvest for growth

When a company earns a profit, there are three main choices of what it can do with its money, aside from simply hanging on to it as cash. We've already mentioned two of them -- dividends and stock buybacks. In addition, companies can choose to use some (or even all) of their profits to reinvest into the business in an effort to fuel growth.

This is why many rapidly growing tech companies like Square, Netflix, and Amazon.com generally don't pay dividends or buy back shares at all. For companies like these, their management teams think that the smartest way to put earnings to work is by funding growth.

On the other hand, many companies have limited potential to reinvest for growth. Think of mature companies like Procter & Gamble, Coca-Cola, and Bank of America. While these companies certainly have some growth opportunities, there's no way that they could responsibly spend all of their profits to fuel growth and expect to earn a strong return on their investment. Furthermore, companies like these don't like to pump all of their profits into dividends, for reasons we'll get into later. So, in addition to their dividend policies, companies like these tend to embrace buybacks as a way to create shareholder value.

Management feels the stock is undervalued

This is one of the more obvious reasons a buyback makes sense. If management feels that a company's stock is trading for less than its true value, buybacks can be a no-brainer.

Think of it this way: If a company's management conducts an analysis and determines that each of its shares has an intrinsic value of $100, but is only trading for $80, it is creating $20 of instant value for shareholders with each share it chooses to buy back.

This is the reason why many companies have somewhat flexible buyback programs. You may hear something like "management may buy back up to $1 billion in shares over the next 12 months, if and when such buybacks are justified by market conditions." One of the more famous buyback plans of recent history is that of Berkshire Hathaway. In order to address CEO Warren Buffett's growing cash problem, it allows the company to buy back as much stock as it wants, provided that Buffett and Vice Chairman Charlie Munger both agree that it trades for a substantial discount to its intrinsic value.

Buybacks can make earnings and growth look stronger

The effect of a share buyback is that there will be fewer shares after the buyback is completed. This may sound like a very obvious statement -- after all, if a company has 1 million outstanding shares and buys back 50,000 of them, it will have 950,000 outstanding shares after the buyback is completed.

However, it's important to consider exactly what this means. After a buyback is completed, the company's profits will be spread out among fewer shares than before, which makes the company's earnings higher on a per-share basis.

Continuing with this example, let's say that a company's profits for a certain year was $5 million. If there were 1 million outstanding shares, this translates to earnings per share, or EPS, of $5.00. Now, if the company had bought back 50,000 of its shares throughout the year, the $5 million in profit would now be spread across 950,000 shares, which means that its earnings would be $5.26 per share. In other words, the company's EPS would be over 5% higher after the buyback, even though its overall profitability is the same.

This can also help make earnings growth look better over time. Let's say that this same company earned a total profit of $5.5 million the following year, a 10% increase from the $5 million it earned the year before. However, we'll also say that the company bought back another 40,000 shares, making its outstanding share count just 910,000 at the end of the year. Dividing $5.5 million by 910,000 shows EPS of $6.04 -- a 15% increase from the year before. Just 10% of this amount was actual profit growth, and the rest is simply because there are fewer shares to spread the profits across.

Buybacks are easier to cut or modify during tough times

Investors expect dividends to be steady and predictable, and if they're growing over time, that's a definite plus. On the other hand, there are few ways to make a stock's price drop faster than by cutting or eliminating a dividend due to a lack of profitability.

In other words, companies want to do everything in their power to prevent from having to cut their dividends, so many tend to keep dividends at a reasonably low percentage of total profits. As a simplified example, if a company only pays out 30% of its profits in the form of dividends, its earnings can plunge by as much as 70% and there will still be enough money coming in to sustain the dividend.

On the other hand, buybacks are a far less scrutinized form of returning capital. And there's often a considerable amount of flexibility built into a company's buyback plan. When times get tough and profits shrink, a company can simply decide to buy back fewer shares than it otherwise would. Investors may be a bit disappointed, but it's likely to pale in comparison to what would happen if a company was forced to slash its dividend.

Buybacks can be more tax-friendly for investors

From an investor's perspective, stock buybacks can be a preferable method of returning capital because of their tax implications or lack thereof.

If you hold stock in a standard (taxable) brokerage account, you'll probably have to pay tax on the dividends you receive each year. Though most U.S. stock dividends meet the definition of "qualified dividends," this still translates to a 15% or 20% dividend tax rate for the majority of investors.

On the other hand, you don't pay tax on capital gains until you sell the investment. Buybacks help increase earnings per share, and therefore can help boost a stock's price, but as long as you hold the stock in your account, you won't have to pay a dime in taxes.

Billionaire investor Warren Buffett has used this exact argument when discussing why Berkshire Hathaway, where he is CEO, doesn't pay a dividend. In short, it gives his investors tax flexibility. Buffett feels that if Berkshire shareholders need income, they can simply choose to sell a certain percentage of their shares each year. On the other hand, if investors don't need income, they can choose to let their shares grow indefinitely without worry of receiving a tax bill. For this reason, Berkshire's response to its ever-increasing mountain of cash has been to expand its buyback program, as I mentioned earlier -- not to initiate a dividend.

Buybacks can help offset stock-based compensation

As a final reason, many companies offer stock-based compensation to their employees, which can have a dilutive effect over time. For example, if a company with 1 million outstanding shares issues 20,000 new shares to its employees this year as part of their compensation, each of the existing shares will represent 2% less equity in the company.

However, if the company chose to buy back 20,000 shares as well, it will negate the dilutive effect of issuing the new shares to employees.

Drawbacks of stock buybacks

Stock buybacks have become quite controversial lately, mainly for economic reasons, which I'll get into in a later section. However, there are a few other downsides to buybacks from a company's perspective.

For one thing, buybacks can reduce a company's cash reserves, giving it less of a "cushion" in tough times, and making its balance sheet look less healthy overall. In other words, a company with $10 billion of net cash in the bank looks significantly healthier than one who spent every last dime on buybacks.

This is especially true if a company uses debt to finance its buybacks. Now, in some cases this can certainly make sense on paper -- for instance, if a company can borrow money at 3% interest and it determines that it can get a 10% return on its investment for buying back shares, it may seem like a smart idea. However, this type of strategy should be used very carefully, or it can have devastating effects if the economy turns.

It's also important to realize that managers cannot predict the future price of their company's stock, so it's entirely possible to overpay. For example, if a company buys back $1 billion worth of stock at $100 per share and it proceeds to fall to $80, the buyback effectively destroyed some shareholder value.

What happens to the shares a company buys back?

One logical question that investors often ask is "What happens to the stock after a company buys it back?"

There are two main possibilities. The company can choose to retire the shares it buys back, effectively taking them out of existence. Alternatively, the company can decide to keep the shares in its treasury, in which case they will be known as treasury shares and can be reissued at some point in the future.

How do companies repurchase shares?

By far, the most common way companies buy back their shares is on the open market. In other words, the company will use a broker to purchase a specified amount of shares, much in the same way you or I would do if we wanted to buy stock in a company (but probably on a much larger scale). Roughly 95% of stock buybacks take place on the open market.

Open market buybacks have the ability to move a stock's price. Basic supply and demand economics says that a surge in demand (like a company wanting to buy back millions of shares at once) puts upward pressure on the price of an asset. In fact, economists have remarked in recent years that companies buying their own stock back is the only reason the post-financial crisis bull market has lasted as long as it has.

Because of this, there are limits to how much stock a company can buy back on the open market. For example, companies cannot repurchase more than 25% of the average trading volume of a stock, in order to prevent the supply and-demand dynamics from getting completely out of control.

In addition to open market purchases, there are a few other ways companies can choose to buy back stock:

  • A fixed-price tender offer essentially invites shareholders to voluntarily sell their shares at a specified offer price. Shareholders can decide whether to participate or not, and it's possible that not enough shareholders will choose to sell their shares.
  • A Dutch auction is a method by which a company will offer a price range, then allow investors to specify any price within the range at which they'd be willing to sell their shares. The buyback will take place at the lowest price that allows the company to buy back the desired number of shares, and all shareholders whose bids were at or below that price will receive the same amount for their shares.
  • Private negotiations with shareholders might allow companies to buy back shares if the above options fail. One example is Phillips 66, which decided to repurchase 35 million shares of its stock, all of which were owned by Berkshire Hathaway.  
  • Put options are contracts that allow their holders to sell shares of their stock at a specified price before a predetermined expiration date. By selling put options, companies receive an up-front premium payment and agree to buy back stock if it falls below the contract price (also known as the strike price). This allows companies to essentially choose a price where its stock would be cheap enough to justify buying back shares in bulk, and to collect premium income even if the stock doesn't drop to the desired price level. 

Stock buyback controversies

Controversy has surrounded buybacks for several years now, but it has really heated up since the passage of the Tax Cuts and Jobs Act in late 2017.

Throughout most of modern history, the vast majority of capital returned to shareholders by publicly traded companies was returned in the form of dividends. However, buybacks have surged in popularity over the past few decades. Now, combined with dividends, most of the net income by the largest American corporations is being returned to shareholders.

When the Tax Cuts and Jobs Act lowered the corporate tax rate beginning with the 2018 tax year and allowed companies to repatriate $2.6 trillion in foreign-held cash, a main argument by proponents of the legislation claimed that the extra after-tax profits corporations would have could be used to reinvest in their businesses, thereby creating jobs and increasing wages.

But it doesn't look like that's happened -- at least, not to the extent many had hoped. Companies seem to be passing most of their tax benefit along to shareholders, and most of the increase has come in the form of buybacks. In fact, 2018 saw the highest buyback volume in history, with total announced stock buybacks topping $1 trillion for the first time in history.

According to a 2019 analysis of Russell 1000 companies, 61% of the benefits of tax reform have been passed through to shareholders. Twenty percent has been used for job creation, and just 6% has been used for the benefit of existing workers.

To be fair, there are sold arguments to be made that buybacks help the economy as well, by giving investors higher net worth, which can then increase their financial health, borrowing ability, confidence, etc. And if buybacks drive share prices higher, it could help all Americans who have interests in the stock market (such as people with 401(k)s), not just the wealthy. However, there's still a huge debate surrounding corporate buybacks, and some politicians have gone so far as to call for a total ban of stock buybacks.

While an outright ban on stock buybacks is highly unlikely, the topic is likely to be present in the headlines for the foreseeable future, so it's important to know the basic ideas behind the debate.

The bottom line on stock buybacks

Stock buybacks are a powerful way companies can choose to give capital back to shareholders, although they're certainly a less visible way than through dividends. By understanding how stock buybacks work, you can understand companies' capital return plans better, and can make more informed investment decisions -- especially when it comes to companies whose dividends may seem rather low at first glance.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Matthew Frankel, CFP has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon, Berkshire Hathaway (B shares), Netflix, and Square. The Motley Fool is short shares of Procter & Gamble. The Motley Fool has a disclosure policy.