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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.
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:
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
Some important reasons why companies may choose to buy back their own stock include:
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.
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:
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.
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.
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.
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.
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.
Stock buybacks are subject to an excise tax of 1% per $1 million in repurchased shares.