What Is a Stock Buyback?

by Advice Chaser
by Advice Chaser

If you read the financial news, you might sometimes hear news of stock buybacks. This is when a company buys shares of its own stock on the open market. Why would they want to do that? And what results does this have on the company, the investors, and the economy as a whole?

Stock Buybacks

Unlike in a stock split, when a company buys back its own stock, any stock you own is unaffected. By buying back their stock on the open market from investors who want to sell, it reduces the total amount of stock without a reverse stock split. It pays the market rate and brings a larger share of the company back under their control.

There are many reasons companies do stock buybacks. Offering stock at all is generally in the interest of raising capital for their expansions. If the members of the board feel they don’t need more capital and would rather have a larger share of the company, they might want to invest in buying back their stock. This is similar to paying off a loan: they reinvest some of the money they got by offering the stock, and in return they own a larger share of their company. This also reduces the amount of dividends they will have to pay.

In addition, a stock buyback reduces the amount of stock available on the market. This can be desired to counteract new stock that has been issued, for instance, as part of employee compensation. If the company issues too much, it could dilute the value of their existing stock, and they can correct this by buying some back. 

Reducing the total amount of stock means that, assuming demand remains about the same, the price per share may go up. During a rough economic period, many companies buy back stock to keep their price from going too low, causing the stock to look like it isn’t doing well. If this boosts the share price, it can later reissue these stocks at a higher price. That way the company has increased its equity without increasing the total number of shares available.

Effects of Stock Buybacks

After a stock buyback, there is often a boost in share price. Also, because the company’s profits are now divided by a smaller number of shareholders, the dividends per share will increase. This makes the stock look more attractive. Both before and after the buyback, a flurry of interest may increase the value of the stock. 

Many investors prefer a stock buyback to dividends. If the company paid them dividends, they’d owe taxes. But with a stock buyback, their shares increase in value without creating a taxable event. They only have to pay taxes when they sell the stock, which they can do when it’s convenient.

However, buying back a large amount of stock costs money. Either the company dips into its cash reserves, or it has to borrow. Either way, it can leave the company in a vulnerable place if things go badly. 

Buying back stock isn’t right for every situation. It’s common when a company feels it is in a strong position, but the share price isn’t reflecting that. It trades cash reserves for a higher valuation. However, if a company does so to boost stock price when it’s not doing that well, it may end up putting itself in a worse position by using up cash reserves or taking on debt.

Recent Developments

Stock buybacks have been a popular choice for many large companies since the 1980s, increasing in the last two decades. However, many are concerned that buying back stock can benefit a company’s stock price at the cost of its cash reserves. Many of these stock buybacks are financed by debt. This results in companies with a high stock price that appear to be doing very well, but in reality are not investing in their long-term success. If the company isn’t putting money into R&D, investing in its employees, or keeping reserves available for a rainy day, it’s vulnerable to market fluctuations. Companies that look good from a stock price perspective may turn out to be built on sand.

The  practice may be somewhat curbed by the August 2022 Inflation Reduction Act, effective in 2023. This added a new tax of 1% on stock buybacks under certain conditions. This does not apply to buybacks under $1 million , and real estate investment trusts and regulated investment companies are also exempt. Investors may see more companies choosing to pay dividends instead of buying back stock. However, since the tax is small, the effect will likely be slight as well.

Talk to Your Advisor About Stock Buybacks

If a company you own shares in is buying back stock, this could be good for you. The shares will likely increase in value. But it might also be a reason to take a long look at the company itself. Is it demonstrating stable growth, or just looking good from the outside?Your financial advisor is the number one resource to help you look into these questions. If you don’t yet have an advisor you trust, we can connect you with the right person. Simply contact us and tell us your specific needs, and we’ll do the rest.

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