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What Are Stock Buybacks and How Do They Work?

Stock buyback programs have their pros and cons — with company insiders gaining the biggest advantages
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What are stock buybacks and how should shareholders respond when companies are buying back shares of stocks — especially at an accelerated rate?

The definition is simple enough, it’s the reason why companies buy back shares of their own stock that needs explaining.

A stock buyback is when a company does just that – buys back shares of its own stock.

Public companies do so quite often. U.S. companies purchased $710 billion of their own shares of stock, which is actually a decline of 15% compared to 2018, according to Goldman Sachs  (GS) - Get Free Report. In 2020, share buybacks are expected to decline by another 5%, Goldman Sachs reports.

U.S. companies may view the current bull market as excessive and are betting on a slowdown. After all, the main reason a publicly-traded company engages in share buybacks is that in doing so, that company lowers the number of stock shares available, which not only triggers a rise in share prices, it also strengthens earnings per share numbers for the company.

A Brief History of Stock Buybacks

Right up until 1982, the history of stock buybacks was written by regulators who didn’t approve of them and sought to prevent so-called “stock manipulators” from leveraging them. The fact is, stock buybacks were illegal in the decades leading up to the go-go 1980s when regulations on stock buybacks were relaxed by the U.S. Securities and Exchange Commission in 1982.

That move came from an adjustment from Rule 10b-18, which originated in the Securities and Exchange Act of 1934, “which provides issuers with a "safe harbor" from liability for manipulation when they repurchase their common stock in the market.”

When the SEC loosened the rules on stock buybacks, all bets were off, as corporate executives quickly realized that by buying back shares of their company stock in bulk, they could inflate their company stock’s value and inflate EPS – both benchmark areas for C-Level executives when year-end bonuses were calculated and doled out.

Why Companies Buy Back Stocks

That said, companies do have other, more above-board reasons for buying back shares of stock.

It can boost confidence in the company and its stock. If a company’s stock is sinking in exchange trading, a share buyback program can restore value in the stock, and in turn, send a positive signal of confidence to investors and potentially drive share prices upward.

It can save on cash. Companies may also accelerate stock buyback programs to save on cash outflows and consequently keep stock dividend payments at current levels. This not only results in fewer dividends having to be paid out (as the company purchases more shares of its own stock), it enables the firm to remain financially viable even as it pours cash into stock buyback programs.

Balance sheet benefits. Companies also turn to share buybacks to further stabilize their financial outlook by curbing the number of financial assets on their own balance sheets. This paints a more positive picture of a company’s return on equity and returns on assets scenario, which in turn helps a company’s financial standing and fuels more confidence in its stock.

To bolster employee compensation plans. Companies may also leverage stock buybacks to keep premiere company talent via stock compensation programs. By buying shares of its own stock and giving those shares to high company producers, the company is keeping its best employees in house. For their part, employees who gain stock option benefits can sell their shares after a specific period of time at a rate calculated into the vested amount of their stock compensation benefits. 

How Stock Buybacks Work

There are several ways companies can engineer a stock buyback.

Once a company decides it wants to engage in a stock buyback, it usually brings aboard an investment bank to handle the preparation, paperwork, and process of executing a share buyback program.

The investment bank will advise the company on the scheduling and the amount of capital it can allocate to its share buyback strategy.

The investment bank will also contact shareholders on behalf of the company to voluntarily return a portion of their shares to the firm. The shareholders can determine how many shares they’ll make available for a buyback and opt for a suitable price range, which is provided by company financial executives.

A company looking to buy back shares can also purchase them in the open trading market from all of its shareholders. Here, all a company has to do is buy back its own shares from sellers at current market prices, whenever they can, and at any amount, they want (subject to internal buy-back limits.)

Under this scenario, companies are trading under the same conditions as all market investors, with no overt outside advantages or special pricing or discounts.

Downsides of Stock Buyback Programs

Shareholders tend to generally approve of share buybacks over the long-term, as they often lead to higher share prices, a higher percentage of shares owned (as buyback programs lead to fewer shares owned by shareholders), and the ability to defer capital gains taxes as share prices rise.

Shareholders also likely sleep better at night knowing a company that can afford a significant share buyback campaign likely has little or no cash flow problems.

But there are downsides to the stock buyback program, as follows:

Possible top. Shareholders may view a share buyback program as a sign that the underlying stock is maxed out, with no room for upward growth. Fair or unfair, there’s plenty of sentiment on Wall Street that share buybacks are triggered by companies to artificially boost stock prices.

Priorities are out of whack. Shareholders may well wonder if a share buyback program is being undertaken, at least in part, to artificially boost company earnings and the stock’s share price, which are both tied to executive compensation. Fiddling with the stock price to increase a senior vice president’s bonus won’t sit well with shareholders – if that’s the reality or at least the perception.

Short-term gains irk long-term shareholders. Upon the immediate news of a company share buyback program, the underlying stock price often jets upward thanks to the cash infusion of management. But any short-term upward momentum after a buyback announcement is likely short-lived, as the usual fundamentals that drive stock prices up (like demand for a company’s product, strong earnings, or a new merger, aren’t really in play at the time.)

Controversy Tied to Share Buyback Programs

With looser regulations governing share buyback policies, more companies are engaging in them and more buybacks are stacking up.

According to government figures, the number of stock buybacks in the U.S. has grown (in dollar amounts) from $6.6 billion in 1980 to approximately $200 billion in 2006. By 2019, that figure had grown to about $1 trillion.

All that buyback has activity has stirred up some controversy in regulatory and advocacy circles.

One source of irritation is when company executives take their amped bonuses earned from stock buyback programs and selling company shares as soon as possible. Meanwhile, average investors are buying into a stock that starts to fall as more insiders sell their shares.

In 2017 and 2018, company insiders were found to be twice more likely to sell shares in the immediate aftermath of a buyback announcement, according to the SEC. What’s more, the price they sell their shares for is five times higher than the average sale price of the same stock in non-share buyback periods.

In that regard, company stock buyback programs have as many cons as pros, especially about the built-in advantages company insiders have over the trading public during buyback periods.

But that’s not stopping companies from engaging in them in 2020 and beyond, even at a decelerated rate - to the advantage of some and the disadvantage of others.