Are Stock Buybacks a Good Thing, or Not?

Fact checked by Suzanne KvilhaugReviewed by Julius Mansa

Large companies flush with cash have been increasingly repurchasing stock shares over the last few decades to boost share prices and return shareholder value. In fact, the value of S&P 500 share repurchases has been higher than those companies’ total dividends every year since 1997.

Some view repurchases as a bad practice, while others argue they benefit both the company and investors. Beyond the financial world, public officials have noticed their increasing use and have called for reforms to push companies toward other uses of their profits. In 2023, companies had to start paying a 1% excise tax on share repurchases, and the U.S. Securities and Exchange Commission (SEC) has been working to expand transparency rules to force companies to divulge how much they engage in the practice.

So, are buybacks bad for investors? Are there knock-on effects that are bad for the wider public? We’ll touch on their advantages and disadvantages below.

Key Takeaways

• Although they can provide benefits, stock buybacks have been questioned in recent years.
• There’s been a significant rise in buybacks in the last few decades, with some companies looking to take advantage of undervalued stocks while others are said to want to boost their stock prices artificially.
• Buybacks can help increase the value of stock options, which are part of many executives’ compensation packages.
• Buyback programs have some advantages over dividends.

Why Do a Stock Buyback?

For corporations with extra cash, there are essentially four choices to make: 

1. They can spend it on their business.
2. They can issue cash dividends to shareholders.
3. They can buy another company or business unit.
4. They can use the money to repurchase their shares, which is a stock buyback.

Like a dividend, a stock buyback is a way to return capital to shareholders. A dividend is effectively a cash bonus amounting to a percentage of a shareholder’s total stock value. However, during stock buybacks, shareholders can sell their stocks back to the company for cash, usually at a premium price. Those shares are pulled out of circulation and taken off the market until they are reissued or dissolved.

Stock Buyback History

The SEC didn’t allow stock buybacks until 1982. That’s when it issued Rule 10b-18, which provided a “safe harbor” allowing them under specific conditions:

• Timing: Companies must use a single broker or dealer for all buybacks within a trading session. Also, buybacks are not allowed within 30 minutes of the beginning or end of the trading day (if the company’s value is above $150 million; otherwise, it’s 10 minutes).
• Prices: The prices paid for the shares must not exceed the highest independent bid or the last independent transaction price quoted when the purchase is made. This is to prevent companies from driving up the stock price artificially.
• Volume: The number of shares bought back in any single day must not exceed 25% of the stock’s average daily trading volume over the previous four weeks.
• Manner: The SEC requires all buybacks to be done in good faith and without the intent to manipulate the stock price.

Since 1997, more has been paid out each year through stock options than dividends from companies in the S&P 500. Over time, dividends have become a smaller part of the picture for investors than before. In the 1980s, the dividend yield for the S&P 500 was typically between 3.5% and 5.5%. In recent years, it’s been under 2.0%.

Below are the numbers for the last five years. A 1% excise tax in effect for 2023 and high interest rates dampened the numbers that year, though 2024 has seen increases in stock buybacks again.

Buybacks vs. Dividends

Buybacks and dividends distribute excess cash and compensate shareholders. Given a choice, many investors would choose a dividend over higher-value stock; some rely on the regular payouts that dividends provide.

However, companies might be wary of establishing a dividend program. Once shareholders get used to the payouts, it’s difficult to discontinue or reduce them—even when that’s best for the company. Decreases in dividends can lead to a stock slide. That said, the majority of profitable companies do pay dividends.

Buybacks benefit all shareholders to the extent that when stock is repurchased, shareholders get market value plus a premium from the company. If the stock price rises before the repurchase, those selling their shares in the open market will see a tangible benefit. The company buying back stock also has flexibility, unlike with dividends, which are paid at fixed times. They can delay or change a stock buyback program should circumstances call for it.

Pros and Cons of Stock Buybacks

Pros

• Increases EPS by reducing outstanding shares

• Boosts short-term stock prices, benefiting shareholders

• Provides a tax-efficient way to return cash to shareholders compared with dividends

• Demonstrates confidence in the company’s prospects

• Helps offset dilution from employee stock options and equity grants

Cons

• May signal a lack of productive investment prospects

• Can divert funds from research and development, capital expenditures, or acquisitions

• Sometimes viewed as a form of market manipulation

• May prioritize short-term gains over long-term growth

• Could lead to excessive leverage if funded by debt

Share Buyback Advantages

The theory behind share buybacks is that they reduce the number of shares available in the market and, all else being equal, increase earnings per share (EPS) on the remaining shares, rewarding shareholders. Bumping up the EPS can be tempting for companies flush with cash.

Apple’s Record $110 Billion Buyback

In May 2024, Apple Inc. (AAPL) announced the largest stock buyback plan in U.S. history, a planned $110 billion. This surpasses the company’s own record of $100 billion in 2018.

Here are other reasons a company might buy back its stock:

• The stock is undervalued and a good buy at the present market price: Billionaire investor Warren Buffett uses stock buybacks when he feels that shares of his own company, Berkshire Hathaway Inc. (BRK.A), are trading too low.
• A buyback will create a level of support: During a recessionary period or market correction, buybacks are thought to create a lower boundary, making it harder for prices to go below a certain point.
• A buyback will increase share prices: Stocks trade in part based on supply and demand, and a cut in the number of outstanding shares often causes a price increase. Therefore, a company can increase its stock value by creating a supply shock through a share repurchase.
• Buybacks increase the demand for a company’s shares. As a result, open-market buybacks automatically lift a company’s stock price, even if only temporarily, and can enable the company to hit quarterly EPS targets.

Buybacks can also be a way for a company to protect itself from a hostile takeover or to signal plans to go private.

Stock Buyback Disadvantages

Important

As of 2023, public company stock buybacks are subject to a 1% federal excise tax.

An important metric for judging a company’s financial position is its EPS. This is the ratio of a company’s total earnings to the number of outstanding shares; a higher number indicates a stronger financial position. By repurchasing its stock, a company decreases the number of outstanding shares. A company can, therefore, boost its EPS ratio while doing nothing to increase its long-term value.

Suppose there is a company with yearly earnings of $10 million and 500,000 outstanding shares. This company’s EPS, then, is $20. If it repurchases 100,000 of its outstanding shares, its EPS immediately increases to $25, even though its earnings have not budged. Investors who use EPS to gauge financial position may view it as stronger than a similar firm with an EPS of $20. In reality, it’s the buyback that made the difference.

Important

Some economists and investors argue that using excess cash to buy up stocks in the open market is the opposite of what companies should be doing, which is reinvesting to facilitate growth (as well as job creation and capacity).

Criticism of Stock Buybacks

As share repurchases have become increasingly prevalent among corporations in recent years, the practice has drawn notable criticism from various stakeholders, including investors, financial analysts, and policymakers. To better understand these concerns, we can categorize them into two main groups: intra-market and extra-market effects.

Intra-market critiques focus on the potential drawbacks of share buybacks within the context of financial markets and corporate performance. Here are some of the problems suggested:

1. Short-term focus: Buybacks encourage a short-term mindset among executives, prioritizing immediate stock price boosts over long-term investments in research and development, as well as sustainable growth.
2. Masking underperformance/market: It’s too easy for companies to use buybacks to artificially inflate EPS, potentially to conceal underlying weaknesses in their financial performance or business model.
3. Misallocating resources: The funds used for buybacks could be better invested in capital expenditures, employee training, or other initiatives that contribute to the company’s long-term competitiveness, not the relative price of shares. This can lead to underinvestment in critical areas that would otherwise fuel future growth and stability. A 2020 Harvard Business Review article reviewed then-recent data showing S&P 500 companies that bought back stocks but put zero capital into research and development.
4. Insider enrichment: Linking the above concerns is a worry that, since buybacks disproportionately benefit executives and insiders who hold large amounts of company stock, decisions about buybacks don’t have the needs of shareholders and the company front and center.

Extra-market critiques move beyond the financial implications for immediate stakeholders and consider their broader societal and economic consequences. Here is some of what is argued:

1. Market manipulation: Concerns about creating fraudulent valuations are also intra-market since buybacks, it’s suggested, can mislead investors about a company’s true financial health and help create asset bubbles. This is the reason for their ban until 1982. However, there are macroeconomic and broader policy effects that buybacks lend credence to the belief that the market is a rigged game for insiders.
2. Wealth inequality: Buybacks may exacerbate wealth disparities, as they tend to benefit wealthier individuals who own the majority of corporate stock while providing limited benefits to workers and the broader economy. There’s also the opportunity cost: when a company spends on stock buybacks, it’s not hiring more workers. This tamps down demand for labor and can be a factor in flattening wagers.
3. Economic efficiency: Behind much of the debate is that buybacks are economically inefficient, not just because they steer money away from potential areas of business growth. There’s also a sense that stock buybacks are part of the financialization of the U.S. economy, helping to change how we understand what corporations are for. The focus of companies should be on finding productive uses for capital—to simplify; they should make things or provide services—and supply steady employment for their workers. It’s hard to see how buybacks accomplish any of these.
4. The role of private equity: Private equity firms, it’s argued, use share buybacks to generate returns after acquiring a company. By employing the acquired company’s cash or taking on additional debt to repurchase shares, private equity firms can increase their ownership stake and potentially boost the company’s stock price. However, this approach can leave the company vulnerable to economic downturns and with fewer resources for long-term investments.

For example, Bed Bath & Beyond declared bankruptcy in April 2023 after spending $11.7 billion on share buybacks from the time of the financial crisis up to its collapse. The company’s workforce had shrunk from 65,000 employees in 2017 to just 20,000 in 2023, but it was still spending hundreds of millions buying back stock. Similarly, Hertz Global Holdings filed for bankruptcy in 2020, laying off 20,000 workers and reducing its fleet by a third. The company emerged from bankruptcy under the control of private equity backers, including CK Amarillo LP, which then initiated $2.8 billion in buybacks in 2021 and 2022. This occurred even as Hertz struggled with a fleet of relatively unpopular electric cars, including Teslas, which increased costs on repairs significantly over gas-powered vehicles.

Critics argue that these cases illustrate how private equity firms can use share buybacks to prioritize short-term gains over long-term stability and growth. By focusing on buybacks rather than investments in the company’s operations or workforce, private equity firms may leave the acquired companies more vulnerable to economic shocks and less equipped to compete in the long run.

Many researchers are working on studying the effects of stock buybacks, and there is no consensus on each of these critiques in the academic literature. A 2023 Journal of Financial Management study gathered data to support its claim “that share repurchases are a mainstream corporate activity that for the most part do not harm the overall market, but do provide various benefits to firms.” While researchers can and should analyze the authors’ models and how they used data that others have employed to argue the other way, one point implicit through their article is unassailable: stock buybacks are so ubiquitous that testing specific claims about outcomes entails much of what the stock market does now.

In addition, while empirical studies can provide valuable insights into the effects of stock buybacks on various aspects of corporate behavior and performance, they can’t answer questions that bring in competing visions of the role and responsibilities of corporations in society. Critics of buybacks argue that the practice represents taking away resources that would be better spent on employee wages and benefits or investments that could lead to more jobs later. Meanwhile, proponents contend that returning excess cash to shareholders is a legitimate and efficient use of capital and that restricting this practice could lead to unintended consequences. These are policy and political questions, not just financial ones.

Who Benefits From a Stock Buyback?

Companies benefit from a stock buyback because it can preserve stock prices, consolidate ownership, and take the place of dividends. Investors can benefit because they receive their capital back. However, a repurchase doesn’t always benefit investors.

How Might Stock Buybacks Contribute to Income Inequality?

Buybacks could lead to an increase in share prices, primarily benefiting wealthier shareholders and investors, as stock ownership is disproportionately concentrated among higher income brackets. In addition, funds used for buybacks could alternatively be invested in employee compensation, training, or hiring. Furthermore, executive pay packages frequently include stock options, and buybacks can directly benefit executives whose compensation is tied to stock performance, widening the pay gap between top executives and average workers.

What Happens to the Stock Price After a Buyback?

A stock buyback could initiate a surge in price because there will be fewer shares available. Some investors might also help push the price up by purchasing stocks before the buyback, hoping to make a profit on the sale.

The Bottom Line

Share repurchases have always had their advantages and disadvantages. But as the amount spent on them each year outweighs total dividends, what effects they have on companies is a major question in finance. Some corporate finance analysts argue that companies use them as a disingenuous method to inflate specific financial ratios, such as EPS, under the auspices of providing a benefit to shareholders. Stock buybacks also enable companies to put upward pressure on share prices by affecting a sudden decrease in supply. However, some argue that these companies are simply making the most efficient use of their resources.

Investors shouldn’t judge a stock based solely on the company’s buyback program, though it is worth considering when investing. A company purchasing shares too aggressively might be reckless in other areas. By contrast, a company that repurchases shares only under the most stringent circumstances (unreasonably low share price, stock not very closely held) is likelier to have its shareholders’ best interests at heart.

You should also remember to focus on the stalwarts of steady growth, price as a reasonable multiple of earnings, and adaptability. That way, you’ll have a better chance of participating in value creation, not value extraction.

Read the original article on Investopedia.