Quite apart from their potential for creating value, share buybacks can also offer companies a shareholder-friendly way to distribute cash. That’s because, in the United States at least, many investors are taxed more highly on cash dividends than on capital appreciation. In my experience, however, a buyback needs to have a materiality level of at least 5% to trigger any appreciable revaluation of the stock price by the market. The size of the potential gain to the shareholders who stayed in was therefore large enough to prompt the market to look more closely at the company and consequently revalue its shares by as much as 30%.
However, if it repurchases 10,000 of those shares, reducing its total outstanding shares to 90,000, its EPS increases to $111.11 without any actual increase in earnings. For example, assume a company issues 100,000 shares at $25 per share, raising $2.5 million in equity. An ill-timed news item questioning the company’s leadership ethics causes panicked shareholders to begin to sell, driving the price down to $15 per share. The company decides to repurchase 50,000 shares at $15 per share for a total outlay of $750,000 and wait out the frenzy. However, investors may be reluctant to purchase the re-issued shares if they feel they’ve been burned by a company this way. If the economy slows or falls into recession, a company might be forced to cut its dividends to preserve cash.
Share buybacks let shareholders choose whether they want to receive cash or not, which has implications for annual income ] and income taxes. Dividends return cash to all shareholders, regardless of their preferences—when a company pays a dividend, every shareholder receives cash. Since stock buybacks remove cash from a company’s balance sheet and potentially reduce the number of shares outstanding, they can have a wide impact on the key metrics investors use to value a public company. Prior to this, corporations generally weren’t taxed at all if they repurchased their shares and boosted value for their shareholders. This is contrary to the tax treatment of dividends, which is a portion of a company’s earnings distributed to shareholders.
An (almost) tax-free way to return capital
Companies need to use their money wisely to succeed in the long term while keeping shareholders happy. If anything, responsible buybacks can be a driver of long-term stock price increases, if it turns out that management bought back shares for less than their intrinsic value. The point of a stock buyback program is to increase the price of the company’s stock on the open market. When investors want to sell their stock, it’s usually a sign the company is overvalued and/or headed for financial trouble, and the stock price will decline as a result. When the company decides to buy back some of its shares, it increases demand for the stock, and the price per share will rise. Suppose the total market value of your company (debt and equity combined) is $1 billion, its shares are trading at $20, and you wish to shift your company’s capital structure from 25% debt to 40% debt.
There are several ways in which a company can return wealth to its shareholders. Although stock price appreciation and dividends are the two most common ways, there are other ways for companies to share their wealth with investors. Investors can benefit from stock buybacks because the practice has generally taken the place of dividends.
Stock Buybacks: Benefits of Share Repurchases
But, like most investing topics, there are pros and cons, as well as good and bad ways, to use stock buybacks. For example, many companies buy back stock regardless of price or valuation and can end up paying more than intrinsic value, especially in strong market environments. Meanwhile, when a company uses excess profits to buy back stock, it doesn’t create a taxable event for shareholders. A share buyback is beneficial for a company if it has no reason to fund expansions or other projects or wants to influence its share price in the market.
- Second, when financed by a debt issue, buybacks can significantly change a company’s capital structure, increasing its reliance on debt and decreasing its reliance on equity.
- The point of a stock buyback program is to increase the price of the company’s stock on the open market.
- An ill-timed news item questioning the company’s leadership ethics causes panicked shareholders to begin to sell, driving the price down to $15 per share.
McConnell and Koski both say that the new tax could have a negative effect on future stock buybacks, although they’re uncertain how much it will move the needle. They also generally agree that rising interest rates could make stock buybacks less appealing for companies. Both think tanks also say the tax could raise billions of dollars in the next few years. Stock buybacks can certainly increase share prices — but are they a good use of company money? In his 2023 State of the Union address, President Joe Biden said he wants to “quadruple the tax on corporate stock buybacks to encourage long-term investments instead.” It’s also worth noting that there’s a big difference between shares bought back with cash and shares repurchased with borrowed money.
Improving Financial Ratios
Once a company buys back its own stock, these shares are either canceled or held in the company’s treasury reserves. In most cases, the company will cancel the shares, which reduces the number of outstanding shares. Canceling shares reduces the number of shares in existence, so the remaining stockholders will receive a larger portion of the dividends. Every shareholder will receive a certain portion of the profits based on the number of shares they own compared to the number of shares outstanding. Investors will often look at the average return of stocks when placing their bets.
This means that now there are only 80,000 shares of Eggshell Candies in existence, instead of the original 100,000. If you’re looking for a reliable way to elevate your investing education, look no further. Now you can access The Real Investing Course — part of the Real Vision Academy — without committing to an annual membership… and at 40% discount. In his State of the Union address, Biden said he wants to bump that tax to 4%. A few days later, Democratic Sens. Ron Wyden of Oregon and Sherrod Brown of Ohio introduced the Stock Buyback Accountability Act of 2023, which would do that.
The market typically perceives a buyback as a positive indicator for a company, and the share price often shoots up following a buyback. The company generally benefits, but a repurchase can also pay off for investors if a business is struggling because they can reinvest the capital into a better performing company. Legendary investor Warren Buffett has commented frequently on the merits of share repurchases over the years and has called their disciplined use the surest way for a company to use its cash intelligently. Bankrate follows a strict editorial policy, so you can trust that we’re putting your interests first. Our award-winning editors and reporters create honest and accurate content to help you make the right financial decisions. When a company reduces the number of shares outstanding, each of your shares becomes more valuable.
It’s easier to cut buybacks in tough times
As mentioned, buybacks can make earnings growth look significantly stronger than it truly is, and investors use metrics such as earnings growth rates and the P/E ratio when valuing companies. Public companies use share buybacks to return profits to their investors. When a company buys back its own stock, it’s reducing the number of shares outstanding and increasing the value of the remaining shares, which can be a good thing for shareholders.
The latter can be a red flag that the company is doing a buyback just to improve some of its metrics and not because it’s in the best interest of shareholders. On the other hand, buybacks come and go, and investors don’t really worry about it — at least not to the extent that they worry about dividend cuts. So companies might choose to use profits for buybacks instead of committing to paying a dividend since it gives them more financial flexibility in the future.
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