What Are Stock Buyback Programs and Why Should You Be Watching For Them?

What Are Stock Buyback Programs and Why Should You Be Watching For Them?

Long-term investors in a particular stock might be familiar with the term ‘stock buyback’, which is a common occurrence on the stock market. Stock buybacks are a great way for companies to remunerate shareholders by buying their own free-float shares and so reducing the total amount of shares available for purchase. While the supply of the shares decreases, the demand stays largely unchanged, which increases the stock price and potentially hikes up the dividend yields for investors. 

This is the key reason why most investors look at share repurchases as positive events and a sign that the issuing company is confident in the long-term growth prospects of their shares. 

However, share buybacks do not happen without a reason and first-time investors need to understand the core purposes of stock buybacks to know when it is welcomed by investors and when these could be problematic. 

If you are a beginner investor who would like to know more about what stock buybacks are and why shareholders should take notice - this investfox guide is for you. 

What Is A Stock Buyback and How Does It Work?

Before diving into some key reasons for companies to buy back their stock, let’s first consider what stock buyback programs are and how they function within the broader scope of company operations. 

Here is the general description of a typical stock buyback program - step by step:

  1. The board of directors authorizes the stock buyback program and sets a limit on the number of shares to be repurchased by the company
  2. The board also decides the funding method of the stock buyback program, whether to use their cash reserves, debt, or future earnings 
  3. Once the buyback has been approved and funding secured, the company can start repurchasing its shares. This can be done on the open market, or via direct negotiations with existing shareholders
  4. After the shares have been repurchased, the company may either choose to retire the shares or hold them as treasury stock, which can be reissued at a later date

While the process of stock buybacks is typically informal, the reasoning behind stock buyback programs can vary from company to company. 

"Capital spending is four times bigger than stock buybacks." - Nancy Lazar

Why Do Companies Repurchase Their Stock?

Some important reasons why companies may choose to buy back their own stock include:

  • To increase shareholder value - when companies buy their own shares, it decreases the total amount of free float that can be purchased on the stock market, while not reducing the overall demand for the stock. This pushes the stock price higher and rewards investors with unrealized gains on their holdings 
  • To manage capital more efficiently - when companies generate excess cash during a particular fiscal year but do not intend on declaring dividends, they can simply use the excess cash to buy their own shares and return capital to shareholders without needing to declare dividends
  • To show confidence - share repurchases can signal to investors that the company is confident in its future performance and financial stability. This can lead to increased investor confidence and a higher stock price
  • As a defensive measure - when under threat of a hostile takeover, companies can buy back their stock as a defensive measure. By reducing the total number of outstanding shares, the company becomes more expensive to acquire 
  • To offset dilution - stock buybacks can also offset the dilution caused by employee stock options by reducing outstanding shares

These are only a handful of reasons why companies may choose to buy their own shares and most of them serve to provide shareholder value one way or the other. 

Potential Drawbacks Of Stock Buyback Programs

While we have highlighted some key reasons why stock buybacks may be a net positive for shareholders, they do come with a fair amount of risk. If not done properly, share buybacks can greatly damage the balance sheet of a company, especially if the company is already going through some operational difficulties. Some potential pitfalls to account for include:

  • Overpaying - if the board decides to buy back shares at a high valuation, it can hurt existing shareholders. This is because the company is essentially using shareholder funds to buy back shares at an inflated price, which can reduce the value of the remaining shares. This is often the case with stock buybacks, as most companies choose to initiate repurchase programs when they have sufficient amounts of cash. It is not uncommon for stock prices to fall after the effects of share repurchases have worn off
  • Neglecting investments - when companies have decent cash reserves, they always have the option to invest more into developing their business and making long-term investments. An excessive focus on stock buybacks can cause the board of directors to neglect some key investments that could have been made using existing cash reserves
  • Financial risks - If a company engages in share repurchases when it is financially unstable, it can put shareholders at risk. The company may not have the necessary capital to support future operations, which can jeopardize the entire business

As we can see, stock buyback programs can be a double-edged sword when made during times of financial instability and can hurt existing shareholders. 

Taxation Of Stock Buyback Programs

When a company repurchases its own shares and sells them at a later date, capital gains taxes may apply. Additionally, companies have to pay a 1% excise tax on every stock buyback that exceeds the $1 million threshold. The rule applies to any U.S. company that is trading on a major exchange, such as the Nasdaq and NYSE. 

If the company holds shares as treasury stock - no immediate tax implications apply. This is also the case when the company chooses to retire its shares. 

Why Should Shareholders Watch For Stock Buybacks?

Stock buybacks can directly affect the performance of stocks held by shareholders. While the overall impact is generally positive for shareholders, share repurchases are not regularly done by companies and it can be difficult to rely on them as stable sources of shareholder value. 

Companies may also buy back their shares at the wrong time, which can have adverse effects on stock performance and reduce shareholder value. 

This is why shareholders must keep track of the number of shares being bought back by the company, which is public information and can be found in quarterly and annual reports issued. If a company is excessively buying up its own shares, this could either be a sign of managerial confidence, or an attempt to cover up some short-term operational issues going on, which can quickly exacerbate if the board is not careful. 

Key Takeaways From What Are Stock Buyback Programs and Why Should You Be Watching For Them

  • Stock buybacks are a common way for companies to increase shareholder value by reducing the number of outstanding shares on the market
  • Companies can either retire repurchased shares or reissue them at a later date in the future. Retired shares are completely taken out of the market and the overall number of outstanding shares decreases
  • While stock buybacks are popular among investors, they can cause major problems if not done properly, or at the wrong time
  • Share buybacks are subject only to a 1% excise tax per $1 million in share repurchases, but selling these shares is taxed as capital gains 
  • Stock buybacks can often happen when a company has robust cash reserves, which may drive up the stock price in the short term, but eventually lead to a sizable drop once the effects of the buyback have subsided

FAQs On Stock Buyback Programs

Why do companies have stock buyback programs?

Stock buyback programs exist to increase shareholder value. When a company buys back its own stock, this reduces the number of shares available for trading, which drives up the value of already existing shares for shareholders. 

Are buybacks good for the company’s stock price?

Stock buybacks reduce the public float of the company, thus, driving up the stock price of existing shares. So if done correctly and for the right reasons, buybacks are generally good.

Are stock buybacks taxed in the United States?

Stock buybacks are subject to an excise tax of 1% per $1 million in repurchased shares.