As a shareholder, you must understand the way your company rewards you on your investment. A company will keep you updated about its financials, allow you to vote at company meetings and reward you when it has enough cash and flexibility. There are different ways a company rewards investors. Besides issuing dividends to share profits with shareholders, companies return money to shareholders through stock buybacks. This is an alternative approach to paying dividends.
Benzinga breaks down what a stock buyback is and how it benefits the investor.
Stock Buyback: Overview
A stock buyback, also known as a share repurchase, is when a public company uses cash to buy back its own shares from the market. It improves shareholder value because it decreases the number of available shares in the market and improves the stock price. For a company, it boosts the earnings per share (EPS) and enhances the market value of employees’ stock options.
Once the company repurchases shares, they can retain them or cancel them. If they are canceled, they become ineligible for voting rights or dividends. Once canceled, they have no role to play in the company’s equity structure.
Apple set a record for the largest buyback in U.S. history in 2024. Its $110 billion stock buyback plan was the largest in U.S.and the stock price soared after the announcement.
There are various opinions on stock buybacks and many believe that it inflates the financial performance metrics of a company. Others believe it diverts the funds from more beneficial investments like research and development. There is no right or wrong here. Each situation and each company is different, but as a shareholder, one should know and understand their rights with regard to stock buybacks.
Financial Implications of Stock Buybacks on Investors
Stock repurchase programs or buybacks are used as a strategy by public companies to handle their finances and increase shareholder value. Whenever a company buys back its shares, it will evidently reduce the number of shares available in the market, which potentially raises the stock price.
A stock buyback also shows that the company is confident about the future and thinks shares are undervalued. Investors must consider the impact of a stock buyback on their share value and overall investment strategy. The next sections will discuss the financial effects of stock buybacks, detailing the benefits and potential drawbacks for investors.
Benefits Of Stock Buybacks For Investors
Increased Ownership Stake
Stock buybacks have a direct impact on the outstanding shares of the company. As discussed above, a buyback will reduce the outstanding shares and increase the ownership percentage for existing shareholders.
With limited outstanding shares, each share will represent a larger portion of the company, thus leading to a higher valuation per share. Shareholders benefit from this and it increases the potential for higher returns.
Higher ROI
The demand and supply of shares have an impact on the stock price. When the available shares are reduced in number, the demand will be higher than supply and this will push the prices over time. A buyback is also seen as a sign of the company’s strength and this leads to a higher demand for the stock.
Shareholders often sell their shares after a buyback and may see a higher return on investment (ROI) due to the increased demand for the shares. There are times when the share prices go up before the buyback. If shareholders sell at that time, they make a higher profit.
Increased Portfolio Earning Potential
Stock buybacks impact the earnings per share of a company. The EPS or earnings per share is the net income of the company subtracted by preferred dividends and then divided by the number of outstanding common stock. With a reduction in the number of outstanding shares, the total earnings will be divided into fewer shares and this leads to a higher EPS.
Further, the cash used for buybacks will reduce the company’s assets on the balance sheet and improve financial ratios like return on assets and return on equity. This signals higher profitability and better capital structure. Thus, companies that conduct stock buybacks are seen as promising investments.
What Should Investors Do After a Stock Buyback?
Investors need to get a complete picture before they commit to a buyback. It can benefit shareholders if the firm is undervalued and has cash. But, if a company is doing the repurchase to meet the profit needs of the senior management, it will not work in the long term. Investors must understand that a share buyback will create a buzz in the market and it will have a positive market impression.
However, sometimes companies use buybacks to inflate the stock prices and it happens when the company is struggling to grow organically. This raises concerns about long-term sustainability. There could be an immediate price rise, but it will not work for the long term.
It could lead to a misleading narrative. Hence, long-term shareholders need to consider the pros and cons before considering a buyback. In case of a stock buyback, your options are buy/sell or hold. We discuss them in detail below.
Sell Your Shares Back to the Company
Short-term investors may want to sell the shares at a higher price to the company. This will increase short-term gains since the company will be paying a premium.
Keep Your Shares
Since buybacks reduce the outstanding shares available in the market, there is a strong chance of a price rise. If you want to increase the ownership stake in the company, keep your shares. And if you are a long-term investor, you will get better value by holding your shares.
Buy the Shares to Flip at a Higher Price
If you are certain about the fundamentals of the company and are bullish on it, you can buy the shares at a lower price when the management announces the buyback and then sell them for a higher price after the price has consolidated.
The Motive Behind Stock Buybacks
Right from boosting the stock prices to redistributing wealth, there are diverse reasons for a company to consider a buyback. Here are a few of them.
Boost Share Prices
The core objective behind any stock buyback is a higher share price. If the board believes that the company’s stock is undervalued, it will decide to buy back shares. The news of a stock buyback shows confidence in the business and signifies that the company has strong growth prospects. If the shares were sinking or there wasn’t enough cash on hand, companies wouldn’t consider a stock buyback.
Offset Dilution
Several companies today offer stock options to employees to attract and retain top talent. In such cases, the options exercised over time can increase the number of outstanding shares in the market and thus dilute the current shareholders’ stake. A stock buyback has a counter-effect.
Hostile Takeover Defense
In case there is a potential hostile takeover, the management might repurchase its shares to reduce the chances of a potential bidder getting a controlling stake.
Reward investors
Companies execute buybacks to reward investors for their investment. It is one of the primary ways for investors to make a profit. It maximizes shareholder return.
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Frequently Asked Questions
Will I have to sell my shares in a buyback?
It is not mandatory to sell your shares when a company announces a share repurchase program. Buybacks are voluntary and companies cannot force shareholders to sell their shares.
How is a buyback taxed?
Stock buybacks allow shareholders to defer capital gains. Buybacks are taxed at the capital gains tax rate in contrast to dividends taxed at the ordinary income tax. This is one reason why investors love stock buybacks. If you hold the stock for more than a year, the gains will be subject to a lower capital gains rate. When you sell the stock back to the company, you pay capital gains tax on the profits. But if you hold it for more than a year, you pay the long-term capital gains tax rate, which is lower than the ordinary income tax rate. In the case of dividends, you end up paying the ordinary income tax on the total amount.
Why not return capital to shareholders through dividends only?
For companies, stock buybacks can be a better option than dividends since they increase the value of remaining shares, are tax-efficient and offer flexibility in managing capital. Dividend distribution may not be possible in times of financial uncertainty or when the company needs cash to invest in growth opportunities. By using stock buybacks and dividends, companies can make the most of their capital allocation and provide value to shareholders.
About AJ Fabino
AJ Fabino is the Investing & Cryptocurrency Editor at Benzinga, overseeing a range of financial content, including stocks, ETFs, options, mutual funds, futures, IPOs, bonds, and cryptocurrency. With extensive experience in financial journalism and content strategy, AJ is dedicated to delivering engaging, insightful, and timely news that empowers readers to make informed investment decisions.
