Deciphering Stock Buybacks: Balancing Pros and Pitfalls

In our last piece, we explained how stock buybacks generally work, and why we prefer investing in a globally diversified investment portfolio over chasing or fleeing particular buyback opportunities. Next, let’s look at how companies use stock buybacks in practice.

Striking a Balance: Buy Back or Plow In?

Broadly speaking, stock buybacks are meant to deliver value to a company’s shareholders in two potential forms:

A bump in share value: Removing shares from the public exchange increases the per-share worth of remaining shares. As one of the world’s best-known business owners Warren Buffett described in his 2022 Berkshire Hathaway shareholder letter: “The math isn’t complicated: When the share count goes down, your [shareholder] interest in our many businesses goes up.”

An opportunity to sell: Those on the sell side of a stock buyback presumably profit from the trade, or at least have some incentive to sell shares.

At the same time, your company (if you’re a shareholder and/or an employee) must spend some of its retained earnings during a buyback, or potentially even take on debt. Clearly, this leaves less cash in the company coffers for other purposes.

As such, a stock buyback represents a trade-off between two opposing forces: enhancing shareholder returns, versus preserving enough capital to continue delivering solid value moving forward.

A company’s management, its employees, and its investors should typically want to strike an appropriate balance between sustaining current and future value. Stock buybacks can (but don’t always) help make this happen.

Why Do Companies Repurchase Their Own Stock?

How and when does a company decide a stock buyback represents shareholders’ best interests, and the best use of its capital? There are a number of reasons a company may embark on a buyback offer.

Distributing “excess” capital: If a company is thriving, with what feels like a cash surplus on its books, its board may decide to reward shareholders with the aforementioned boost in stock value. If the buyback offer is appealing, current shareholders may also take some of their gains off the table by selling shares back to the company.

One argument goes: If a company has more cash than it really needs, a buyback may make more sense than spending the money mindlessly, at the ultimate expense of its shareholders. Here’s how The Wall Street Journal columnist Jason Zweig has described it:

“Expecting oodles of surplus cash not to burn a hole in the typical CEO’s pocket, however, is like putting a pile of raw meat in front of a lion and expecting it not to disappear. My favorite examples come from the 1970s, when—just like now—giant oil companies had vastly more capital than they could plow back into their existing wells.”

Creating tax-efficiency: You may have noticed a similarity between stock buybacks and dividend distributions. For both, the company pays out capital to shareholders … with a tax twist. Dividend distributions are taxable when they occur. In a stock buyback, your shares increase in value, but you’re only taxed on a gain when/if you sell them. Thus, stock buybacks are considered a more tax-friendly way to distribute capital to company shareholders, at least in taxable accounts.

Managing share dilution: If a fast-growing startup (for example) has leaned heavily on stock options to recruit and retain employees, these options can start to dilute the stock’s per-share value once employees begin exercising them. If the company has thrived, it may choose to buy back some of its “excess” shares, to maintain good value on the remainder.

Fighting a takeover bid: A stock buyback is expected to increase share value, as described above. Obviously, the higher the share price, the more expensive it becomes to snatch up new shares. Thus, a stock buyback is one way a company may try to prevent a hostile takeover.

Stock Buybacks: Risks Amidst the Rewards

So far, we’ve summarized the ways stock buybacks can be an effective tool in the right hands, delivering powerful, tax-efficient value to shareholders, without necessarily stunting future growth. In our next piece, we’ll look at how this same power tool can end up being weaponized in the wrong hands, and why the government is keeping an eye on the practice.