A Share Buyback Explained

What is a Share Buyback?

A share buyback is when a corporation purchases its own stock in the open market with excess cash and sometimes debt. The activity is also referred to as share repurchases, stock repurchases or stock buybacks. Anyone owning the stock can participate, but it is not a requirement.

Companies have several possible uses for their cash flow or excess cash on the balance sheet. For instance, they can employ their cash flow to reinvest in the company, pay down debt, pay a regular dividend, pay a special dividend, repurchase shares, or acquire another company.

Reasons Why Companies Buy Back Shares

Corporations perform share buybacks for a few reasons. One is to reduce dilution to existing shareholders from stock options given to employees. This level is usually a low level of buybacks and keeps the share count relatively constant.

Next, company management may feel the stock is trading at a low valuation. For instance, market action may lower the stock price, making it undervalued relative to historical valuation averages. When this occurs, companies typically start buying back shares.

Another use is to hide lower net income because a lower share count impact earnings per share (EPS), as discussed below.

Lastly, a corporation may decide they cannot find a better use for the excess cash. In this case, the company often does not want to pay dividends, and leverage is already low. A share buyback is an effective way to return cash to shareholders. For example, Alphabet does not pay a dividend and repurchases billion of dollars of stock annually.

Alternatively, they may desire to maintain a fixed dividend payout ratio. Then, only a certain amount of cash is needed to keep the ratio constant. After that, the excess money is held on the balance sheet or used for a share buyback.

Impact of a Share Buyback

A share buyback reduces the quantity of shares. The repurchased shares are canceled and held in the corporation’s treasury. Also, the share equity is diminished.

Besides lowering the share count, this action increases the EPS because of the lower share count. Additionally, this change reduces the price-to-earnings ratio because the share price is the same, but the EPS is higher.

A share buyback only indirectly affects other valuation methods. For instance, the Gordon Growth Model Formula relies on dividend growth rates to estimate a stock price. This quantity is not directly affected by a share repurchase. However, suppose a lower share count increases the future dividend growth rate, then the stock’s value rises based on a new rate.

Also, less cash on the balance sheet improves the return on assets (ROA) and return on equity (ROE) metrics.

Pros of a Share Buyback

A share buyback can make a stock attractive to investors by increasing EPS and lowering valuation. Also, a lower share count can mean less cash flow required for dividends suggesting a future higher dividend growth rate.

Next, some evidence exists suggesting share buybacks boost the stock price immediately after the announcement. But conversely, other research demonstrates no long-term effect on total returns. 

Moreover, some investors don’t like paying taxes on dividends each year. A share buyback is more tax efficient and avoids dividend taxes. However, an investor selling back shares to the corporation may result in a capital gains tax.

Cons of Share Buybacks

Share buybacks have several cons. The main one is some investors view it as a poor use of cash. Instead, excess cash should be used for capital investment, reducing debt, or saving for a recession when cash flow is affected.

Second, many CEOs often buy back shares when the share price is too high, a circumstance especially true for high-priced tech companies with simultaneously high valuations. In these instances, a share buyback destroys value.

Next, some corporations use debt to repurchase shares, especially when interest rates are low—no doubt this is a poor use of debt. However, once interest rates rise, these companies are saddled with debt and pay higher rates.

Lastly, a new 1% share buyback tax took effect in the United States on January 1, 2023, making repurchasing more expensive. But the new tax will be paid by corporations and not investors. In 2021, companies repurchased a record $881.7 billion of their stock. Consequently, the U.S. Treasury stands to gain about $9 billion per year at that pace.

Warren Buffett’s Opinion

Warren Buffett is a fan of share repurchases if it is performed in a disciplined manner. His 2011 annual letter listed two necessary conditions for share buybacks. He states:

“Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.”

In 2021, Berkshire Hathaway bought back $24,706 million, the eighth most significant amount of US companies.

Largest Buybacks in 2021

Technology companies are typically the ones doing the most buybacks. Of these, Apple (AAPL) is usually number one. In 2021, companies repurchased $881.7 billion of shares, a record. This dollar value was ~69.6% more than in 2020.

 The table below shows the most significant share buybacks in 2021.

Final Thoughts on A Share Buyback Explained

Almost every company executes a share buyback periodically. When done correctly with excess cash, it can be a prudent use of money. However, there are several disadvantages that investors should know. Moreover, if a CEO and management prioritize stock repurchases over other requirements, value can be destroyed.

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