What Is a Stock Buyback?

Stock buybacks have been rising in recent years as a means for public companies to give money back to investors. Large U.S. companies have spent over $3.9 trillion in the last five years on stock repurchases, according to S&P 500 Dow Jones Indices. But what are stock buybacks exactly, and why don't companies just pay the money out as dividends? 

In fact, some go even farther and want to know why the money isn't just used by the company.

Here, we answer the question "what is a stock buyback," and take a closer look at why corporations undergo "share repurchases," as they are also called. Then we'll uncover what their benefits are and why some folks don't like them.

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How does a stock buyback work?

When a public company announces a share repurchase program, it generally states the amount of money that it will spend buying shares in the market.

That means that willing shareholders sell their stock in the company through market operations. They generally do not know who the buyer is, or whether the company is repurchasing its own shares.

It's also not very common for a company to announce the number of shares it plans on buying back, rather they give a dollar amount. Take Wells Fargo (WFC), which announced in mid-2023 that its board of directors approved a new $30 billion share repurchase program.

By giving a dollar amount, the company is able to gauge market conditions and decide whether the stock price on any particular day is in the target range of what they will pay. Once the company buys the shares, it generally cancels them, thereby reducing the total number of shares outstanding. Then, at the end of the quarter, it will announce how many shares were bought and the average price paid.

Why would a company buy back shares? 

Sterilization. One major purpose of buybacks is sterilization, which is the cancellation of shares that are otherwise issued to employees when their stock options or restricted stock rewards and benefits are issued. In other words, the total number of shares does not increase, as the buybacks sterilize the normal growth in share growth.

Leverage. A second reason companies buy back shares is to effect a change in the stock price. This force effect occurs two ways.

First, all the share buyback activity provides a natural buyer in the market that keeps the price elevated. 

Second, the stock can rise as the calculation of earnings per share rises. With less shares outstanding, the earnings divided by the average share count each goes up. So, assuming the market rates the company with the same price-to-earnings multiple, the stock price will tend to rise over time.

Efficient return. But a third and even more important reason for stock buybacks is the tax efficient way it returns capital to investors.

This can be seen several ways. The simplest way to understand this is the fact that over time, a company that does stock buybacks can significantly increase its dividends per share. This is also done without increasing the cost of the dividends to the company.

In effect, the payments that otherwise would be used for dividend increases are spent buying back stock. So, with fewer shares outstanding, the normal dividend will rise on a per-share basis.

Another way to see this is to compare the results of a company that buys back its shares vs a company that doesn't but increases the dividend instead. The after-tax return to the buyback shareholders is always greater.

I have written about this effect extensively throughout my career. My calculations show that a person who owns stock in a company that raises its dividend, but does not buy back shares, will pay more income tax. Moreover, all things being equal, dividends per share will not rise and neither will the stock price. So shareholders have a limited return.

But the company that buys back its shares will produce a higher stock price because as its shares count falls, it forces the price higher. This assumes the market valuation stays level and all other things are equal. Moreover, that effect produces more value for shareholders, as they pay no taxes on this unrealized gain (until they sell shares).

In effect, buyback companies help their shareholders by efficiently returning capital to them. This is mainly by avoiding double taxation of the money otherwise spent on dividend payments.

Is a stock buyback a good thing?

As part of the Inflation Reduction Act of 2022, buybacks are now taxed to the tune of 1.0%. But the Biden administration wants to raise that tax substantially. They believe buybacks limit public companies' spending on corporate initiatives that will benefit all its stakeholders, not just shareholders.

But many disagree with this, including Warren Buffett. He famously wrote in his 2022 letter Berkshire Hathaway (BRK.B) shareholders that buyback detractors are either "economically illiterate or a silver-tongued demagogue (characters that are not mutually exclusive)."

Another criticism is that buybacks only work to the benefit of shareholders if prices are stable or falling. Some companies have been criticized for buying back shares at market peaks. After all, that means the company may have overpaid, especially if the stock never recovers.

However, the vast majority of companies that buy back shares have benefited from share repurchases even as their stock price is rising.

After all, since buybacks are so popular with investors, it actually has had an ancillary leverage effect. Buybacks, both from the market effect and the leverage effect, tend to push up stock prices. Companies now assume that they will have to keep buying shares at higher and higher prices.

But perhaps the best rebuttal of buyback criticism is the fact that almost all companies that pursue large buybacks have free cash flow (FCF). This means that all the buyback money is "free" to be spent after all expenses and capital expenditures have already been deducted from operating cash flow.

The bottom line is that buybacks tend to work to the benefit of all shareholders, as Warren Buffett recently pronounced in his recent shareholder letter.

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