Stock buybacks—i.e., a company repurchasing shares of its own stock—have been targets for praise and criticism through the years. So, which are they: good or evil? We agree with The Wall Street Journal columnist Jason Zweig, who once wrote:

“Buybacks are neither bad nor good. They are simply a tool. Just as you can use a hammer either to build a house or knock one down, buybacks are useful in the right corporate hands and dangerous in the wrong ones.”

In other words, a stock buyback can help you, hurt you, or be a neutral event, depending on the particulars. Let’s embark on a balanced look at stock buybacks.

Part I: How Do Stock Buybacks Work?

In general, you and other traders can buy or sell any publicly traded stock on an open exchange like the NASDAQ or New York Stock Exchange (NYSE). Similarly, a company can participate in these same exchanges, using its retained earnings to buy back or extend a tender offer to repurchase some of its own stock.

However, just because a company wants to buy back shares, does not mean you have to sell any of yours. A stock buyback offer is just like any other trade on the open market. Before a trade occurs, would-be buyers and sellers must agree on a fair price. (Note: If you are invested in a mutual fund or ETF, the fund manager decides on your behalf. But the principle remains the same: The buyer and seller must agree on a fair price at which to trade.)

There is also one noteworthy difference between a stock buyback versus simply selling stock to another trader. In a “regular” trade, one of you is the seller, and the other is the buyer. End of story. But when you own a company’s stock, you own a piece of its capital, making you a co-owner. Thus, in a stock buyback, you may have vested interests on both sides of the trade.

And that’s where things get interesting. How do companies use (and occasionally abuse) stock buybacks to deliver sustainable value to its shareholders? We’ll explore that next.

Part II: Sustaining Current and Future Value

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:

1. 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.”
2. 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 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.”

Creating tax-efficiency: You may have noticed a similarity between stock buybacks and dividend distributions (see our recent post on Dividend Stocks). 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.

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. Next, 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.

Part III: Risks Amidst the Rewards

Bad Apples in a Big Cart

First, it’s worth emphasizing that evidence in the U.S. and around the world suggests that most stock buybacks function as hoped for; the bad apples are exceptions to the norm.

For example, a study published in a 2019 Journal of Financial and Quantitative Analysis looked at some 9,000 stock buybacks across 31 countries, from 1998–2010. The authors also compared their results to past U.S. and global studies of similar focus. Describing their work as, “to our knowledge, the most extensive analysis of buybacks around the world,” the authors concluded:

“On average, share repurchases are associated with significant positive short- and long-term excess returns.”

However, not every stock buyback is a beautiful thing. The authors also observed:

“While, on average, buybacks are beneficial for long-term investors, when we dissect the cross-section of buybacks around the world we find evidence supporting a more nuanced view. Not all buybacks are created equal.”

Price vs. Worth

Warren Buffett offered a similar caveat as he extolled the virtue of stock buybacks in his Berkshire Hathaway 2022 shareholder letter:

“Every small [buyback] helps, if repurchases are made at value-accretive prices.”

What did Buffett mean by “value-accretive”? He was talking about whether a stock’s price accurately reflects the company’s true earning power. In other words, given the risk/reward tradeoffs the company faces, is there enough “there” there to warrant the asking price?

Managers, Shareholders, and Everyone Else

If a going enterprise truly has more cash than it can use for value-added purposes, it can make good sense to direct some of its profits back to its shareholders at a fair price.

But who gets to decide it’s time for a buyback, and at what “fair” price? Often, the company’s managing stakeholders are the ones weighing in heavily on these calls. These individuals usually stand to benefit the most during a buyback offer.

Can you smell the potential conflicts of interest? No wonder there are some ill-advised buybacks. Sometimes, a few appear to have pilfered company reserves to fatten their own purses with pumped-up prices. This comes at the ultimate expense of many others—including, potentially, the general public.

As an example, Lehman Brothers executed $4 billion in stock buybacks within six months of its 2008 collapse. Another is Citigroup’s $20 billion in 2004–2008 repurchases (right before it needed a roughly $45 billion government bailout during the financial crisis).

Whether a buyback is ill-fated due to excessive greed or simply unintended consequences, the negative repercussions can be equally unpleasant to those left holding the proverbial bag. Especially if we, the people, end up spending public funds to clean up a mess.

Government Initiatives

Evidence strongly suggests injurious buybacks are the exceptions to an otherwise healthy norm in a productive, relatively free-market economy. But given the stakes involved, perhaps it’s no surprise that the government has been keeping its eye on stock buybacks.

There are also those who feel stock buybacks are receiving an unfairly sweetened tax deal compared to dividend payouts. Both methods distribute company capital to shareholders. But where dividends are taxable in the year incurred, any post-buyback bump in stock value isn’t taxable until shareholders sell their stock for a gain.

These concerns have spurred two avenues of government activity: taxes and regulations.

For example, in July 2023, the Federal Reserve proposed raising capital requirements for at least the nation’s largest banks. In other words, banks would have to increase the amount of capital they’re required to keep on hand, reducing the amount they can use on buybacks. Many banks have halted buyback programs for now, pending resolution of the proposal.

On the tax front, efforts have been aimed at reducing the perceived incentive to favor stock buybacks over dividends, as well as potentially generating an even higher tax windfall from buybacks. Specifically, the Inflation Reduction Act of 2022 has imposed a 1% excise tax on companies making stock buybacks after December 31, 2022. These regulations are still pending,  however, the IRS has also instructed companies to maintain detailed records on any buybacks they perform in 2023 and beyond.

Time will tell how this tax tale ends.

Where Do We Go From Here?

As Americans, each of us is entitled to our opinions on how our government should proceed in taxing and regulating corporate stock buybacks. As financial advisors, our opinion isn’t as important as how we advise you to integrate the information into your personal investments.

For a long-term investor, your best course is to capture market-wide sources of return according to your willingness, ability, and need to take on accompanying market risks. By holding a globally diversified portfolio, you’re highly likely to benefit from an ongoing stream of return-generating stock buybacks, without being overly harmed by the occasional failures.

Beyond that, at least in your role as an investor, you’re probably best off leaving the politics of stock buybacks to the politicians. Vote according to your preferences when the time comes, and stay the course with your diversified investments.

Big Picture: Diversification Is Still Our Best Friend

If you’re familiar with our general investment strategy, our answer will come as no surprise: stay well diversified between and amongst asset classes. Because we can’t predict what can happen with any individual stock, we advise against strategies that engage in market timing or stock picking. That way, you’ll continue to capture long-term market growth without needing to assess each one individually.

Brandon