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Stock buybacks: Why do companies repurchase their own shares and is it good for investors?

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Stock buybacks are surprisingly controversial among investors. Some investors see them as a waste of money, while others regard them as an excellent way to generate tax-advantaged returns for stockholders. Both critics and proponents have good points, but who’s right?

Here’s the upshot: properly executed stock repurchases are one of the best and lowest-risk ways to create value for shareholders. But not all companies execute them properly.

What is a stock buyback and how does it create value?

A stock buyback is when a company repurchases its own stock, typically cancelling it after the repurchase. This effectively reduces the company’s shares outstanding, making the company’s market capitalization smaller for any given stock price. In effect, buybacks “re-slice the pie” of profits into fewer slices, giving more to remaining investors.

A stock buyback is one of four major ways a company can use its cash, including investing in the operations, buying another company and paying out the money as a dividend to investors.

To undertake a stock buyback, a company typically announces a “repurchase authorization,” which details the size of the repurchase, either in terms of the number of shares it might buy, a percentage of its stock or, most typically, a dollar amount. A company may use its own cash or borrow cash to repurchase stock, though the latter is usually riskier.

A company usually repurchases stock in the public market, just as a regular investor would. And so it’s buying from any investor who wants to sell the stock, rather than specific owners. By doing so, the company helps treat all investors fairly, since any investor can sell into the market.

It’s important to understand that, despite an authorization, a company may not buy back shares at all, if management changes its mind, a new priority arises or a crisis hits. Stock buybacks are always done at the prerogative of management, based on the needs of the firm.

Buybacks can elevate investors’ returns significantly, especially when pursued consistently over time. Some shareholders love them as a strategy and those top executives who use them well.

Share buybacks can create value for investors in a few ways:

  • Repurchases return cash to shareholders who want to exit the investment.
  • With a buyback, the company can increase earnings per share, all else 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. If the company is worth $1 billion, but is split fewer ways, each share is worth more.
  • They’re a more tax-efficient way to return the earnings of the business to shareholders, relative to dividends, which are taxable to those who receive them.
  • Via repurchases, the company’s management shows confidence in the business and supports the stock price.

These reasons become all the more compelling if a company buys back stock over time, if it has the excess cash to do so. By reducing share count by even 2 or 3 percent each year, a company can increase a shareholder’s return by a comparable amount each year. And the company may actually take advantage of its own form of dollar-cost averaging.

But just because buybacks can be good doesn’t mean they’re always good. In fact, poor managers have many ways to destroy value or siphon it off to themselves.

Downsides to a stock buyback

Stock buybacks can destroy value as well as create it, and so those who oppose buybacks also make some compelling points about why buybacks can be bad.

Here are a few of the most common reasons against buybacks:

  • Buybacks can be used to cover up stock issuance to managers. If the company issues stock-based compensation to managers, it dilutes the ownership of shareholders. Some management teams use buybacks to obscure how much issuance affects share count.
  • Buybacks may allow managers to enrich themselves at the expense of shareholders. If managers have options (which become valuable once over a specific stock price) and the ability to influence the stock price via repurchases, they may decide that they can temporarily boost the stock price in order to secure a gain on their options.
  • Buybacks can simply be poorly done. If a management team is buying stock at any price, rather than at a good price, it may be wasting shareholder capital. So if a stock is really only worth $100 but a management team is buying it for $150, that destroys value.
  • Buybacks can starve the business of money needed in other areas, such as research and development or investment into new products and facilities.

These are legitimate reasons why specific buybacks may be bad, but each reason relies on self-dealing or incompetent managers to negate the buyback’s value or make it destructive.

However, each reason says more about the managers than about the buyback itself. Properly executed by a competent management team, buybacks are wonderful for investors. And if you’re investing in stocks, you need to analyze executives and have an opinion on them.

Still, sometimes critics argue against buybacks by saying that the money could go elsewhere, such as into operations. This reason may be correct in specific circumstances, such as if a company is starving its research budget in order to buy back stock. That’s up to investors (who own the business) and managers to decide. A well-run company would typically buy its own stock with cash left over from operations or with debt that it could comfortably repay.

So who’s right?

Whether stock buybacks are good or bad depends a lot on who’s doing them, when they’re doing them and why. A company repurchasing stock while it starves other priorities is almost certainly making a huge blunder that will cost shareholders down the road.

But a competent CEO who spends cash on a buyback even after investing effectively in operations? That could be a good investment, because the CEO is focused on putting capital – shareholders’ money – into attractive investments. And if a management team is looking out for shareholders, it’s a good sign for the future of your investment.

To determine whether a specific buyback is a good use of investors’ money, you need to dig into the company and its situation:

  • Why is it conducting the repurchase?
  • Is the buyback simply vacuuming up shares issued to management?
  • Is the buyback a good use of money, in your estimate?
  • Does management have a strong track of delivering returns?

Those are a few of the most fundamental questions to answer, but if your company undertakes a buyback, you need to be able to understand whether it’s a good decision and why.

And that may rely on knowing the broader context. For example, newly public thrift banks regularly repurchase stock as a way to create value for shareholders, and investors expect them to do so.

Bottom line

While repurchases may be controversial from time to time, they’re just another way for a company to invest shareholders’ money. So 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. Invest with a poor management team, and you may get burned.

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Written by
James Royal
Senior investing and wealth management reporter
Bankrate senior reporter James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.
Edited by
Senior wealth editor