Stock buybacks are a way companies create value for investors by reducing the number of shares in the market

• A stock buyback reduces the number of shares freely trading, which usually boosts their value.
• Companies sometimes repurchase shares to offset new ones created under employee stock option plans.
• Buybacks and dividends are both ways to return capital to shareholders, with significantly different tax implications.
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When a company goes public, it sells shares of stock in the open market. Later, if the company decides it wants to reduce the number of publicly traded shares, it can do a stock buyback.

Also known as a share repurchase, a stock buyback is when a company reacquires shares and puts them under its own control. In many cases, companies then retire, or cancel, those shares, which reduces the total supply. With less supply, each shareholder then owns a greater percentage of the company.

Buying back shares can also boost or stabilize stock prices, as the company making the repurchases provides a source of demand for the stock.

How do stock buybacks work? 

Stock buybacks work by companies getting board approval to repurchase their own shares. From there, companies can buy back shares through several methods, including:

• Open market purchases: With open market purchases, companies can buy their own publicly traded shares at their own pace. Companies often use this approach with specific disclosures about the timing, amount, and other aspects of the repurchase laid out in the Securities and Exchange Commission’s Rule 10b-18

• Accelerated share repurchases: A company may work with a dealer to quickly buy back a block of shares, rather than taking the time to accumulate the shares in the open market. The company has to pay for the shares up front, but then the responsibility falls on the dealer to source the shares.

• Tender offers: A tender offer is generally more complex and involves actively and widely soliciting others to sell shares to the company. This offer can be made at either a fixed price or through what’s known as a Dutch auction, where companies will buy back shares within a set price range. 

• Privately negotiated share repurchases: As opposed to making a wide solicitation or open market purchase, a company also might privately negotiate a repurchase from a shareholder.

Why would a company buy back its own stock?

A company can have several reasons for buying back its own stock. Some of the most common include:

Increasing shareholders’ ownership

Buying back stock can reduce the total supply of shares in the market, which means each shareholder can own a larger percentage of equity in the company than they did prior to the buyback.

Offsetting shares created through employee stock options

When employees exercise stock options, that can increase the number of shares outstanding. But rather than letting that reduce the ownership percentage for existing shareholders, companies can buy back shares to offset those given to employees.

Improving financial metrics

Stock buybacks can be used when management and the board thinks the stock is priced too low, and the demand that they provide by buying up stock could help lift the share price for existing investors.

Repurchases could also be used as a way to boost financial metrics like earnings per share (EPS). This aspect of buybacks can be controversial.

“One of the main criticisms of a stock buyback is the positive impact it has on some of the main financial ratios that investors monitor, (such as EPS),” says Michelle Katzen, managing director at HCR Wealth Advisors. “As long as a company is buying back stock for the right reason, this can be a byproduct of the process. However, if this is the main driver of the buyback, it’s cause for question by investors.”

How do stock buybacks affect shareholders? 

Stock buybacks can directly affect shareholders in many ways, ranging from changing their ownership percentage to influencing stock prices. In many cases, investors benefit from buybacks. But there can be a few drawbacks that you should keep in mind, whether you’re an existing shareholder or considering investing in a company that tends to do buybacks.

“I think that buybacks are generally a net positive for investors, but I think it should be a lesser consideration than so many other factors,” says Steve Sosnick, chief strategist at Interactive Brokers. “A buyback isn’t going to turn a poorly managed company into a good company.” 

Benefits

• Reducing the number of shares: Existing shareholders can benefit when stock buybacks reduce the number of shares that exist for a company. “Since the value of the company is the same the moment before and after the buyback, but there are now fewer outstanding shares/owners, each share represents a larger fractional ownership and should presumably be worth more,” says Katzen.

• Increasing demand for the stock: Not only can buybacks provide benefits on the supply side, but they can also increase demand for the stock. That can increase the stock price or at least provide some price support in periods of weak demand.

  “Stock prices, or any asset prices, are determined by supply and demand. And the company is creating demand by buying its shares,” says Sosnick.

• Enabling lucrative employee compensation: If companies want to attract top talent, they may decide to offer lucrative compensation packages that include stock options. If a company endlessly gives out stock, however, that could dilute existing shareholders.

  Yet if a company buys back stock and retires those shares, then existing shareholders don’t have to be diluted. “In some cases, buybacks are equilibrating changes in supply and demand” resulting from issuing stock-based compensation, explains Sosnick. Meanwhile, companies can still gain the benefit of compensating talent. That can help shareholders in the long run, as great employees can help create more value for the company.

Drawbacks

• Suboptimal use of capital: One potential drawback of buybacks is that companies may have been better off using their capital in another way. For example, instead of spending several billion dollars buying back shares, the long-term value of the company may have been better served by making an acquisition or investing in more research and development.
• Conflicts of interest: Another potential downside of stock buybacks is that there can be a potential conflict of interest with some people involved in these decisions, notes Sosnick. Management’s compensation, for example, is often largely stock-based, so buybacks could effectively increase their compensation.

Stock buybacks vs. dividends

Stock buybacks and dividends are both ways a company can return capital to shareholders. However, there are significant differences between them.

In particular, dividends directly provide compensation to shareholders, often in cash. In contrast, stock buybacks don’t necessarily directly return money to all existing shareholders. “The actual money is going to those who are selling the shares,” notes Sosnick. 

That said, existing shareholders can benefit by the value of their positions increasing, so in that sense they’re getting capital returned to them. However, any increase would essentially exist only on paper until an investor sells the stock.

Another significant difference between buybacks and dividends is taxes. Some dividends are taxed at ordinary income tax rates. And even if they qualify for lower rates, an investor could still have to pay taxes for each year they receive dividends. 

In contrast, buybacks wouldn’t directly trigger a taxable event. Instead, the investor could choose when to sell their stock, at which time they may owe capital gains taxes. A rise in stock value resulting from buybacks could mean that the investor eventually pays capital gains taxes on this increase, but the investor has more control over the timing compared with dividends.

Overall, some investors might prefer stock buybacks, such as in the hopes that the stock value will rise, while others might prefer to receive cash from dividends. Both have their pros and cons, but in general, each can ultimately be a way for companies to use some capital to benefit shareholders.

“There are different investor preferences,” says Sosnick. “It’s tough to say that one is better than the other.”