Stock buybacks are surprisingly controversial among investors. Some investors see them as a waste of money, while others regard them as an excellent way to generate tax-advantaged returns for stockholders. Both critics and proponents have good points, but who’s right?
Here’s the upshot: properly executed stock repurchases are one of the best and lowest-risk ways to create shareholder value. But not all companies execute them properly.
What is a stock buyback, and how does it create value?
A stock buyback, or share repurchase, is when a company repurchases its stock, reducing the total number of outstanding shares. In effect, buybacks “re-slice the pie” of profits into fewer slices, giving more to remaining investors.
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A stock buyback is one of the primary ways a company can use its cash, including investing in the operations, paying off debt, buying another company, and paying out the money as a dividend to investors.
To undertake a stock buyback, a company typically announces a “repurchase authorization,” which details the size of the repurchase, either in terms of the number of shares it might buy, a percentage of its stock, or, most typically, a dollar amount. A company may use its own cash or borrow cash to repurchase stock, though the latter is usually riskier.
A company usually repurchases stock in the public market, just as a regular investor would. And so it’s buying from investors who want to sell the stock rather than specific owners. By doing so, the company helps treat all investors fairly since any investor can sell into the market. Investors are under no obligation to sell their shares just because the company is buying back shares.
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It’s important to understand that, despite authorization, a company may not buy back shares if management changes its mind, a new priority arises, or a crisis hits. Stock buybacks are always done at the management’s prerogative, based on the firm’s needs.
Buybacks can elevate investors’ returns significantly, primarily when pursued consistently over time. Some shareholders love them as a strategy, and those top executives who use them well.
Share buybacks can create value for investors in a few ways:
- Repurchases return cash to shareholders who want to exit the investment.
- With a buyback, the company can increase earnings per share, all else equal. The same earnings pie cut into fewer slices is worth a more significant share of the earnings.
- By reducing share count, buybacks increase the stock’s potential upside for shareholders who want to remain owners. Each share is worth more if the company is worth $1 billion but is split in fewer ways.
- They’re a more tax-efficient way to return the business’s earnings to shareholders, relative to dividends, which are taxable to those who receive them.
These reasons become all the more compelling if a company buys back stock over time if it has the excess cash to do so. By reducing share count by 2 or 3 percent each year, a company can increase a shareholder’s return by a comparable amount each year. And the company may take advantage of its own form of dollar-cost averaging.
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But just because buybacks can be good doesn’t mean they’re always good. Poor managers have many ways to destroy value or siphon it off to themselves.
Downsides to a stock buyback
Stock buybacks can destroy value and create it, so those who oppose buybacks also make some compelling points about why buybacks can be harmful.
Here are a few of the most common reasons against buybacks:
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- Buybacks can be used to cover up stock issuance to managers. If the company issues stock-based compensation to managers, it dilutes shareholders’ ownership. Some management teams use buybacks to obscure how much issuance affects share count.
- Buybacks may allow managers to enrich themselves at the expense of shareholders. Suppose managers have options (which become valuable once over a specific stock price) and the ability to influence the stock price via repurchases. In that case, they may decide that they can temporarily boost the stock price to secure a gain on their options.
- Buybacks can simply be poorly done. If a management team buys the stock at any price rather than at a reasonable price, it may be wasting shareholder capital. So if a stock is only worth $100, but a management team buys it for $150, that destroys value.
- Buybacks can starve the business of money needed in other areas, such as research and development or investment into new products and facilities.
These are legitimate reasons why specific buybacks may be bad, but each reason relies on self-dealing or incompetent managers to negate the buyback’s value or make it destructive.
However, each reason says more about the managers than the buyback itself. Executed adequately by a competent management team, buybacks are wonderful for investors. And if you’re investing in stocks, you need to analyze executives and have an opinion on them.
Still, sometimes critics argue against buybacks by saying that the money could go elsewhere, such as into operations. This reason may be correct in specific circumstances, such as if a company is starving its research budget to buy back stock. That’s up to investors (who own the business) and managers to decide. A well-run company would typically buy its own stock with cash left over from operations or with debt it could comfortably repay.
So, are buybacks suitable for investors?
Whether stock buybacks are good or bad depends greatly on who’s doing them, when they’re doing them and why. A company repurchasing stock while it starves other priorities is almost certainly making a huge blunder that will cost shareholders down the road.
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But a competent CEO who spends cash on a buyback even after investing effectively in operations? That could be a good investment because the CEO is focused on putting capital – shareholders’ money – into attractive investments. And if a management team is looking out for shareholders, it’s a good sign for the future of your investment.
To determine whether a specific buyback is a good use of investors’ money, you need to dig into the company and its situation:
- Why is it conducting the repurchase?
- Is the buyback simply vacuuming up shares issued to management?
- Are the shares being repurchased at attractive prices?
- Does management have a strong track record of delivering returns?
Those are a few fundamental questions to answer, but if your company undertakes a buyback, you need to understand whether it’s a good decision and why.
And that may rely on knowing the broader context. For example, newly public thrift banks regularly repurchase stock as a way to create value for shareholders, and investors expect them to do so.
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Which companies are buying back the most stock?
Companies can buy back shares at any time, but share repurchases are typically highest during periods of strong economic activity when companies have the cash available. Technology companies have recently been some of the largest buyers of their own shares.
Here are the companies with the most significant total buybacks during the third quarter of 2021.
- Apple (AAPL) – The iPhone maker repurchased $20.5 billion in shares during the third quarter. Apple is responsible for 17 of the 20 highest quarterly share repurchases in history, according to S&P Global.
- Alphabet (GOOG) – The search giant bought back $15 billion in shares during the third quarter, up from $8.4 billion in the second quarter.
- Meta Platforms (FB) – The company formerly known as Facebook repurchased $12.6 billion in shares during the third quarter, down slightly from $12.8 billion in the second quarter.
- Oracle (ORCL) – Oracle bought back $9.9 billion in shares during the third quarter, up from $4.2 billion in the second quarter.
- Microsoft (MSFT) – The software giant bought back $8.8 billion in shares during the third quarter, up from $8 billion in the second quarter.
Warren Buffett’s views on stock buybacks
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.
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In his 2011 letter to Berkshire Hathaway shareholders, he identified the two conditions that must be met for him to favor a company buying back its own shares.
- The company must have enough money to handle the operational and liquidity needs of the business.
- The company’s shares must be selling at a significant discount to a conservative estimate of their intrinsic business value.
In a later letter, Buffett explained through an example how share repurchases could add or destroy value for shareholders:
“If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies to corporations and their shareholders. Ergo, whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.”
While repurchases may be controversial from time to time, they’re just another way for a company to invest shareholders’ money. So what typically drives whether a buyback is good or bad is the capability of the management and its interest in being a good steward of the money entrusted to it by shareholders. Invest with a poor management team, and you may get burned.
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