Reclamation Projects: How Stock Buybacks Work

As the stock market reels amid concerns over inflation, stagflation, the Federal Reserve’s raising interest rates, Russia’s invasion of Ukraine, and a surge in commodity prices that could stall the economy, corporate stock buybacks are on a record pace in 2022.

Stock buybacks, also known as share buybacks or share repurchase programs, involve a public company using cash to buy shares of its own stock on the open market. Though profitable public companies often return excess cash to shareholders by paying dividends, stock buybacks are another way to reward investors.

In a stock buyback, a company purchases shares of stock on the secondary market from any investors who want to sell. Shareholders are under no obligation to sell their stock back to the company, and a stock buyback doesn’t target any specific group of holders—it’s open to all.

Public companies undertaking a stock buyback typically announce that the board of directors has passed a “repurchase authorization,” which details how much money will be allocated to buy back shares—or, alternatively, the number of shares or percentage of shares outstanding it aims to buy back. (It’s important to note that, despite a board’s repurchase authorization, a company may not buy back shares at all if management changes its mind, a new priority arises, or a crisis occurs. Stock buybacks are always done at the prerogative of management, based on the needs of the firm.)

Record Pace

So far this year, S&P 500 companies have announced $429 billion in buyback activity, a record level representing a stronger year-to-date pace than in the previous high-buyback years of 2019 and 2021. In 2021, S&P 500 companies plowed around $880 billion into buying their own shares, up from $520 billion in 2020, according to S&P Dow Jones Indices.

In the first quarter of 2022, buybacks were up 45% year-over-year and up 3% quarter-over-quarter. Much of that increase came in the tech ($62 billion in stock buybacks), financials ($49 billion), and healthcare ($39 billion) sectors. Energy companies also significantly ramped up their stock-buyback activity as they continued to benefit from higher oil prices; the sector bought back $9.5 billion in stock, compared to just $500 million in the first quarter of 2021.

JPMorgan views the elevated corporate stock buyback activity not overextended and likely to continue, given that businesses are still generating strong cash flow on healthy margins—even in the face of what many market participants view as an elevated risk of recession.

Why Buy Back?

The main reason companies buy back their own stock is to create value (in this case, a rising share price) for their shareholders. Here’s how it works: Whenever there’s demand for a company’s shares, the price of the stock rises. When a company buys its own shares, it’s helping to increase the price for its stock by boosting demand, thereby creating value for all shareholders.

Advantages

• Directly boosts share prices. The main goal of any share repurchase program is to deliver a higher share price. The board may feel that the company’s shares are undervalued, which would make it a good time to buy back. Meanwhile, investors may perceive a buyback as an expression of confidence by the management. After all, why would a company want to buy back stock it anticipated to decline in value?
• With a buyback, the company can increase earnings per share, all else being equal. The same earnings pie, cut into fewer slices, is worth a greater share of the earnings. By reducing share count, buybacks increase the stock’s potential upside for shareholders who want to remain owners.
• Tax efficiency. Dividend payments are taxed as income, whereas rising share values aren’t taxed at all. Any holders who sell their shares back to the company may recognize capital gains taxes, naturally, but shareholders who do not sell reap the reward of a higher share value and no additional taxes.
• Offers more flexibility than dividends. Any company that initiates a new dividend or increases an existing dividend will need to continue making payments over the long term. If they reduce or eliminate the dividend going forward, they risk lower share-values and unhappy investors. Meanwhile, share buybacks are one-offs, which makes them much more flexible tools for management.
• Offsets dilution. Growing companies may find themselves in a race to attract talent. If they issue stock options to retain employees, the options that are exercised over time increase the company’s total number of shares outstanding—and dilute existing shareholders. Buybacks are one way to offset this effect.

Disadvantages

• Poor use of cash. Depending on many factors, stock buybacks may privilege short-term gains in share price when other more profitable uses of the cash are available. Investors worry that buybacks redirect corporate spending away from capital expenditures, research and development, and workers’ wages. Simply stockpiling cash for a rainy day may advance stock prices in the short run at the expense of long-term growth.
• Debt-fueled share buybacks. In the years before the COVID-19 pandemic upset the economy, up to half of all buybacks were financed by taking out debt. Low interest rates incentivized companies to borrow money to spend on share buybacks, which would benefit stock prices in the short term. Critics suggest this was an especially shortsighted strategy.
• Cash-rich companies tend to have high stock prices. Some companies launching stock buybacks have built up a war chest of cash after a period of good performance. Companies in this position also tend to have relatively high share valuations, meaning they may produce less value for shareholders than other uses of the cash would.
• Used to conceal stock-based compensation to executives. Many public companies issue compensation to managers in the form of stock, which dilutes other shareholders. Executives may use buybacks to obscure how this form of compensation impacts the company’s share count.

Impact on a Company’s Value

Since stock buybacks remove cash from a company’s balance sheet and potentially reduce the number of shares outstanding, they can have a wide impact on the key metrics investors use to value a public company.

It’s important to understand that once a company has bought back its own shares, those shares are either canceled—thereby permanently reducing the number of shares outstanding—or held by the company as treasury shares. Treasury shares are not counted as shares outstanding, which has implications for many important measures of a company’s financial fundamentals.

Key metrics such as earnings per share (EPS) are calculated by dividing a company’s net profit by the number of shares outstanding. Reduce the number of shares outstanding and you’ve given a company a higher EPS, which may make the company appear to be performing better. The same thing goes for the price-to-earnings ratio (P/E ratio), which helps investors understand a company’s relative valuation by comparing its stock price to its EPS.

Goldman Sachs analysts raised their 2022 forecasts for buybacks at the end of March to a record $1 trillion, which would represent a 12% rise from 2021, when repurchase activity had propelled the S&P 500 to a 27% gain. The analysts said the breadth of buyback activity is near a historic high; the number of active programs is double the typical figure. We would now expect the total number of buybacks to exceed $1 trillion.

Conclusion: Buyback Value Depends on Circumstance

While repurchases may be controversial from time to time, they’re just another way for a company to invest shareholders’ money. 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.