Stock Buybacks Explained

Corporate America seems to have found a new hobby—aggressively buying back its own stock, but why? 🧐

In 2015, Alphabet Inc. announced it was going to repurchase $5,099,019,513.59 of its class C shares. The company chose that specific number as a “joke”—you get to that number by taking the square root of 26 (number of alphabets) and multiplying it by $1 billion.

However, stock buybacks are no joke. Since the 1980s, American companies have been pursuing stock repurchases aggressively. In theory, stock repurchases can be good for retail shareholders but if they’re done for questionable reasons, they can be devastating for the economy in the long term according to some critics.

As a retail investor, being aware of stock buybacks and how they work will help you make better decisions and higher profits. In this article, we look at what stock buybacks are, how they work, and their impact on retail investors and the economy at large.

What Are Stock Buybacks? 💭 

A stock buyback happens when a company repurchases its outstanding shares. There are several methods a company may use to buy the stock. Still, more than 95% of buybacks are completed via open market purchases.

Since a buyback reduces the number of outstanding shares, it naturally (or somewhat very artificially) increases the shareholder value. Thus, companies can invest in themselves and distribute wealth to their shareholders simultaneously with stock buybacks, which explains the recent meteoric rise in buybacks over the last decade.

There can be many reasons why a company might want to pursue a stock buyback. Sometimes, it is just the most efficient application for capital. However, there could be other motivations too (and not all of them are necessarily good for retail investors like us.)

Why Do Companies Do Stock Buybacks? 🤔

A Gary Vee video might be the reason why your friend chose to “invest in himself.”

However, giant corporations usually need a more substantial justification to buy back their shares. Given how common buybacks have become in today’s economy, though, there certainly isn’t any shortage of solid motives. 

Here are the main reasons why companies do stock buybacks:

Reducing the Cost of Capital 💲

Companies can raise capital by issuing shares or taking on debt. There is a cost associated with both—shareholders will demand a return on their investments via dividends, and lenders will demand loan payments with interest.

In general, debt is cheaper to finance than equity—debt lenders are guaranteed fixed payments with interest while dividends are at the company’s discretion. Additionally, corporate tax law allows companies to get tax reliefs on their interest payments which is not the case with dividends which are taxed on distribution.
So, instead of carrying expensive equity on their books, companies can find it more beneficial to fund themselves with relatively cheaper debt.

Buybacks are typical for companies that already dominate their industry and have little room left for growth. As a result, these companies do not see much benefit in holding equity capital that has little utilization.

The Biggest Stock Buybacks in 2021-Q1

Holding the Stock Price Steady Through Market Turbulence 💰

If you’re a shareholder of some solid dividend-paying stocks, you would expect them to keep paying dividends regularly, right? However, if the economy starts slowing down, the dividend payments could decrease too. While this is bad for you, it is worse for the company, and they can avoid it with stock buybacks.

Let’s look at an example to understand how it works: Company A is a huge blue-chip company that allocates excess capital to shareholders in the form of dividend payments and stock buybacks. The company has a stellar record of paying increasing dividends over the last 5 years, but we just entered a recession.

The company has also pursued a regular stock buyback program over the last five years as it allows them flexibility on distributing profits, and to save more on taxes than dividend payments. However, there is also another advantage.

Since dividends are paid as a percentage of forecasted earnings and for the year, Company A has less profits to distribute to its shareholders due to low revenue generated in the year. 

To make up for the lower profit distribution, it can reduce the money allocated to the stock buybacks instead of the dividend payments. According to prevalent market theories, reducing the buybacks will have a much lower impact on the stock price.

Essentially, a reduction in dividend payments is a worse signal than a reduction in stock buybacks, and companies would rather have the option to reduce the buybacks instead of reducing dividend payments and risk the stock price.

If Company A was not buying back its stock and only paying dividends, it would have had to reduce its dividends payments during the recession, which would undoubtedly lead to a sell-off. Thus, companies can use stock buybacks strategically to stay agile and hold the stock price steady when there is turbulence in the market.

Leveraging its Undervalued Stock to Raise more Capital Later 💸

A company might be motivated to buy back its shares if it firmly believes that its stock is undervalued at the moment. Suppose the company has an optimistic forecast for its future that the market is not reflecting for some reason. In that case, the company can bet on itself with stock buybacks.

In some cases, once the stock price gets back up, the company can also reissue the shares. They say you can’t have your cake and eat it too. Still, in this case, the company does increase its equity capital without diluting the ownership. However, this is usually only the case when the company feels the stock is “well below intrinsic value,” as described by Berkshire Hathaway in their 2019 shareholder letter.

Here’s a quick practical example to understand how this works:

Company A had issued 200,000 shares with a price of $20 per share, raising $4 million in equity capital. Due to a recent market downturn, the share is currently valued at $8. However, the company believes that its stock is criminally undervalued and decides to repurchase 80,000 shares, spending $640,000 in the process.

After two years, the market downturn has ended, and Company A’s stock is soaring to new heights at $35 per share. The company decided to take advantage of this bump and reissue the 80,000 shares it had repurchased, adding $2.8 million in equity capital.

In effect, the company adds $1.2 million to its equity capital without issuing any additional shares and diluting its ownership. Here’s a quick table to explain the difference in the capital structure before and after the buyback.

Making the Financial Statements Look Pretty 💄

For healthy companies, stock buybacks can have the same purpose as a last-minute apartment cleaning before a date. An excellent financial statement, just like a clean apartment, projects that you have got things under control (even though that might not be entirely true.)

A stock buyback has the most significant effect on the following metrics:

1. ☑️ Earnings per share (EPS)—Net income divided by available shares.
2. ☑️ Price to earnings—Share price divided by earnings per share.
3. ☑️ Return on equity—Net Income divided by shareholder’s equity.

As you might have noticed, all three of them share something in common—they are all affected by the number of outstanding shares. So as a share buyback reduces the number of outstanding shares, it positively affects the three metrics and makes the company’s finances look attractive to investors.

Additionally, the news of a buyback is generally seen as a bullish signal by retail which can further increase the stock price, increasing the positive effect on the company’s books.

Simply Reducing the Number of Outstanding Shares 💳

Along with the ones listed above, a company may also want to buy back its shares for the following reason:

1. ☑️ Retain an optimal number of shares after employees exercise their stock options.
2. ☑️ Prevent a future hostile takeover by limiting the number of shares.
3. ☑️ To take advantage of the tax benefits share buybacks offer over dividend payments since capital gains tax is lower than the dividend tax rate.

How Do Stock Buybacks Work? 💵

Unlike us, corporations cannot just fire up their favorite stock trading app and start YOLOing into their own stock like apes. To understand the process of stock buybacks, first let’s take a look at how a public company is structured.

When a company is publicly listed via an initial public offering (IPO), it essentially splits itself into a fixed number of shares. It then proceeds to sell those shares on the stock market. As the shares become listed, they can be traded by investors on the open market as they see fit.

The shares which are freely traded are known as outstanding shares. However, the number of outstanding shares for a company is not static—a company can issue more shares after its IPO for several reasons after approval from the SEC. So, naturally, if the number of outstanding shares increases, the value of a single share decreases.

For some companies, issuing additional shares is not bad if there is room for enough growth in the future. However, having too many outstanding shares can be bad for many companies and lead to bad financial ratios, giving investors a lousy impression.

Thus, companies use stock buybacks to control the number of outstanding shares, which also has positive resonating effects on the company’s finances and its capital structure.

The Stock Buyback Process 💴

To begin buying back its stock, a company first needs to ensure that it actually has the authority to repurchase the stock. Next, the company should look into its organizational documents, the law of the state of incorporation, credit agreements, etc., to avoid any negative legal consequences.

There are also restrictions that the company needs to comply with. For example, a company cannot buy back more than 25% of the average daily average daily stock volume. Additionally, it cannot start a buyback if it has non-public material information about the company.

Once it is clear that the company has the authority to go forward with a stock buyback plan, the board of directors has to authorize and approve the buyback plan. If the board allows the program, the company must release the buyback plan to the public. They are not required to disclose exact details but have to disclose facts like the maximum number of shares that could be repurchased (unless they’re opting to issue tenders for the buyback).

The company should also disclose how the purchases will be made. There are several choices available, but most pick the open market method as it offers a lot of flexibility in execution. 

A company may also choose to buy back its shares using multiple methods simultaneously. For example, buying back from the open market while negotiating a private repurchase from a select investor who might hold a significant amount of that stock. 

An open market buyback plan can last months or even years. The company is not required to commit to open market buybacks and can wait for better market conditions.

As the repurchase plan goes on, the company also has to report its share buyback activities in its periodic reports. In addition, information like the number of shares repurchased and the average price per share is required to be disclosed as per SEC rules and regulations.

Tender Offers 💶

A tender offer is a term that is not defined by the Exchange Act in the context of U.S. securities law. However, courts have come up with some factors to determine what can be considered as a tender offer, such as:

• ☑️ There should be an active and widespread solicitation of shareholders
• ☑️ The purchase offer is made at a premium over the market price
• ☑️ The terms of the offer are not negotiable

Stock buybacks made using a tender offer are not covered by Rule 10b-18, removing the 25% average daily volume limitation. However, there are other heavy disclosures required of a company issuing a tender offer, which is why most companies do not prefer using it.

Private Repurchases 💷

Companies are also allowed to negotiate private repurchases of their stock. Like tender offers, private repurchases are not covered by Rule 10b-18, which means they are not limited by the 25% average daily volume limit. However, private repurchases usually have a tiny number of sellers. Companies can risk the offer being considered an illegal tender and run into high administration costs if there are too many sellers.

What Happens to the Stock after the Buyback? 💱

You might be wondering what happens to the shares that are repurchased by the company. Of course, a company can always cancel them, but they can simply hold them. 

For example, the company might have a plan to reissue the shares at a later date because it believes the stock will go up in the long run, or it might plan to include some of those shares as part of employee compensation, or it could be hoping to use them for acquisitions…

Are Stock Buybacks Really Beneficial? 💡

Stock buybacks are undoubtedly beneficial for the company and the shareholders in the short run but. Let’s say you’re a company with a ton of extra cash. You essentially have four options with what to do with it:

1. ☑️ Invest in the existing business and make capital expenditures.
2. ☑️ Distribute it to shareholders as dividends.
3. ☑️ Acquire a new business or company.
4. ☑️ Repurchase your own stock from the market.

In general, we would expect companies to focus on developing their own capabilities with profits which should lead to better products. On the other hand, the company is also expected to appease its shareholders which it can do using dividends and buybacks. 

Yet over the last decade, companies have been pouring more money into buying back its own stock. Between 2003 and 2012, companies listed on the S&P 500 allocated approximately 54% of their earnings to buybacks.

Naturally, there are several benefits to stock buybacks for companies which is why it’s so popular at the moment, for example:

• ☑️ Provides support for the stock and helps it preserve value during market downturns.
• ☑️ It creates an artificial demand for the stock which leads to an increase in share price.
• ☑️ Allows companies to bet on themselves if they feel their stock is undervalued.
• ☑️ It improves the financial statements and allows the company to control the number of outstanding shares.

However, there has been some criticism for excessive stock buybacks based on the fact that it might not be as beneficial for retail investors.

With stock buybacks, a company can essentially dress up its financial statements and improve key metrics like EPS without actually increasing its earnings. Buybacks can also create a small bump in price which allows the company and insiders to profit but at the expense of long-term sustainable growth. We cover the effects of buybacks on retail investors in-depth further down this article! 

Stock Buybacks vs. Dividends 🏛️

Comparing stock buybacks and dividends is a bit like comparing Batman and Ironman—both of them essentially do the same thing but have a different approach. As discussed previously, companies can distribute profits to their shareholders using dividends, stock buybacks, or a mix of both. Let’s quickly look at the differences between the two from the company’s POV:

Both methods have their advantages and disadvantages for both the company and the investor. Since we expect the executives to know a thing or two about risk management, we’re going to focus on the pros and cons for both from a retail investor’s point of view here.

Stock Buybacks 📊

Dividends 📈

What Do Stock Buybacks Mean for Investors? 🧠

In a perfect world, a stock buyback should be good for the company and the investor, but in reality, it doesn’t always work like that. As an investor, you should be aware of stock buyback plans while researching stocks since they’ll affect you in several ways.

It should be noted that a buyback plan by itself doesn’t mean anything in particular. However, when one looks at the broader implications of mass buybacks by most companies, some problems can emerge.

At the most extreme, investors may shift funds into other asset classes like exchange traded funds (ETFs) since they feel the stock market is artificially inflated due to buybacks.

Understanding the Context ⚖️

A buyback is a business decision taken by the company. Depending on the context, it can be a good sign or a bad sign for a retail investor. If it is clearly evident that the buyback would provide the best return for shareholders with the excess cash, then the buyback makes sense. 

However, in certain situations, a buyback can hurt the investors more than help them. Here are some red lights to look out for:

1. ☑️ The stock price is overvalued already.
2. ☑️ The buyback is pursued just to boost the company’s EPS for the short term.
3. ☑️ The buyback will help the executives meet short-term goals.
4. ☑️ Most of the buyback is financed by borrowed funds. 
5. ☑️ The only purpose of the buyback is to either prevent a hostile takeover or get rid of excess cash that the company hasn’t been able to manage effectively.

AAPL—Example of a Good Buyback for the Retail Investor

In 2019, Apple sent $75 billion in stock buybacks. For 2020, the company bought back shares worth $50 billion. It plans to keep using its cash considerably to buy back its stock. 

For Apple, the motivation of the buyback is to pursue a “more optimal capital structure” in the light of recent tax changes, as stated in a quarterly call in February 2018. In this case, the retail investor has little to worry about, as the company keeps performing exceptionally and dividends keep rising, currently $0.22 per share. 

If you’re an Apple shareholder, you shouldn’t be worried as it’s clear that the end goal for Apple is to increase shareholder wealth. The buybacks are clearly a business decision.

IBM—Example of a Bad Buyback for the Retail Investor 📉

Let’s take the example of another tech giant, IBM. Unlike Apple, IBM has not been performing well for quite a while. The company has spent more than $201 billion on stock buybacks since 1995, but the stock has consistently underperformed against the average stock market return. 

In this case, shareholders might think the company should invest in research and innovation instead of buying back its own shares. But, in the long-term, the buyback hasn’t generated much shareholder wealth at all. To put things in perspective, IBM stands at $140 per share, making its market cap almost half of its spend on buybacks.

While shareholders might appreciate buyback plans, there is always a risk of the company missing out on opportunity costs and stagnating, which translates into lower returns for the investor. A lot of shareholders might consider selling their shares due to the diminishing returns, which further decrease the price.

Types of Stock Buybacks 🛒

Most stock buybacks are done using the open market—the company uses a broker to buy a fixed number of shares from the open market, just like a retail investor, albeit with some restrictions. However, going the open market route isn’t the only option available to the company. Here’s a deeper look at how stock buybacks can work for the company:

Buying from the Open Market 🏬

Using the open market is the most transparent and most commonly-used method for buying back shares. Of course, a company has to announce their stock buyback plans, but they have the liberty to decide when and how much they would buy. 

Since buying from the open market affects the share price, companies can theoretically manipulate their stock price with buybacks. However, companies have to follow Rule 10b-18 that puts forward four conditions that need to be followed if the company wants a “safe harbor” from stock manipulation charges.

The rule’s most important condition is that the company cannot buy more than 25% of the daily average traded volume. 

Private Purchase 🚀

A company may opt to buy back its share directly from one or more shareholders in some cases. Private negotiation occurs between the company and the shareholders, which can be time-consuming but gets a better deal for the company.

Fixed-Price Tender 🪑

A company may also float a fixed-price tender to buy back its stock. The tender price is higher than the market value in most cases. Shareholders can apply for the tender at will and sell their shares at the quoted price. Tenders are usually not preferred by companies since they do not offer as much flexibility. Still, they can be a quick way to buy back.

Dutch Auction Tender 🇳🇱

A dutch auction tender is pretty much the same as a fixed-price tender, except the company offers a price range in this case. Similar to fixed-price tender, the lower end of the spectrum is usually higher than the market price. 

Shareholders can then make bids and submit the number of shares they expect to sell for a minimum price they’re willing to receive. After reviewing the proposals within a fixed period, the company determines the price within the range to complete the buyback process.

The Effect of Stock Buybacks on the Economy ⚙️

Ever since the SEC adopted Rule 10b-18 in the 1980s and allowed companies to repurchase their shares in the open market, stock buybacks have been on a meteoric rise, only to be slowed down by the Great Recession and the COVID-19 pandemic. However, as the economy recovers, companies are already resuming their stock buyback plans.

In theory, it sounds like a good idea for a company to distribute profits to their shareholders with buyback plans, especially if there is no better use for the capital. However, critics of stock buybacks pointed out a worrying trend that was emerging—debt-financed buybacks.

The practice of taking on debt to repurchase shares can often be short-sighted and primed only towards making short-term gains in the stock price. Instead of increasing the capacity of the company to generate more revenue, the debt is utilized to appease shareholders and increase the stock price artificially.

According to a paper published in the Journal of Corporate Finance, “over-levered firms are associated with lower returns and decline in real investments following leveraged buybacks.”

Another worrying trend was that companies have kept buying back shares even though the market has been booming. 

Buybacks Can Be Very Disruptive ⚠️

As discussed previously in this article, it can make sense for a company to buy its share if it is undervalued. However, it seems like companies would rather keep utilizing buybacks to give their stock that extra push in a competitive market. This can lead to artificially inflated stocks and a more pronounced downfall when the cycle bursts.

From 2018 onwards, debt-financed buybacks started dropping massively as companies found more after-tax cash in their hands due to changes in the tax law with the Tax Cuts and Jobs Act of 2017. In Q4 2018, the S&P 500 companies spent $223 billion on buybacks, a 62.8% increase from Q4 2017.

However, the fundamental issues with stock buybacks remain the same—short-term profits are prioritized over long-term growth; executives exploit them for personal gain. Moreover, they can often be financed with debt making the firm less secure in a bear market.

On a macro-economical level, excessive stock buybacks indicate that companies are not interested in funding research and development. For example, 18 leading pharmaceutical firms on the S&P 500 spent 11% more on buybacks and dividends than R&D. 

Even though it might seem like a good deal for both the shareholder and the company, excessive stock buybacks can lead to massive potential problems in the future. In some cases, stock buybacks can be sustainable if done risk-aversely and with the right goals. Still, generally, too many companies choosing to invest in themselves for selfish reasons cannot be suitable for the economy in the long run.

The Legality of Stock Buybacks 📜

Stock buybacks in the open market are regulated by the Securities and Exchange Act (1934) with Rule 10b-11, adopted in 1982. The main legal concerns with stock buybacks relate to market manipulation and insider trading.

Open Market Buybacks and Rule 10b-18 ⛏️

If you’re a company wishing to repurchase stock, you’ll likely do so using the open market. In this case, you need to follow Rule 10b-18, which regulates open market repurchases of stock. 

In effect, Rule 10b-18 provides a company with non-exclusive immunity against some sections of the Exchange Act that relate to market manipulation, such as Sections 9(a)(2) and 10(b). 

The rule only protects a company concerning the stock repurchase. It does not provide immunity from other violations of the Exchange Act. For example, just because a company is complying with Rule 10b-18 for stock buybacks doesn’t mean it has the right to be immune from insider trading and market manipulation laws in general.

Rule 10b-18 mainly relates to four daily conditions that the company must follow while buying its shares: manner, timing, volume, and price. These conditions must be met by the company every day during the buyback plan. Here’s a quick overview of the requirements:

Manner 🤲

All bids/purchases must be made by only one broker/dealer on any single day.

Timing ⏱️

The purchases must not be a part of the opening transaction. They should not be made during the last 10 minutes of trading in the security’s principal market or the market where the security was bought if the average daily trading volume of the stock is at least $1 million. For other stocks, the time limit is 30 minutes before the trading stops.

Volume 🏷️

The aggregated purchases for the day should not exceed 25% of the average daily trade volume. 

Price 🔖

The purchases cannot exceed a price that exceeds the highest independent bid or the last transaction price (whichever is higher.)

It should be noted that the company is not forced to follow Rule 10b-18. Yet, the failure to do so will make the company vulnerable to Sections 9(a)(2) and 10(b) of the Exchange Act for their stock buyback transactions, which most companies understandably want to avoid.

If a company is planning to repurchase its stock from the open market, it must do so in accordance with conditions set down by Rule10b-18 and the Securities and Exchange Act (1934). Failure to do so can result in market manipulation charges against the company.

Insider Trading and Rule 10b5-1 🛠️

Generally, if a company or an employee has material non-public information, it should not be buying back its shares since it would be considered insider trading. However, to get around this issue, a company may use a Rule 10b5-1 trading plan. 

A Rule 10b5-1 trading plan, simply put, allows companies to add a delay to their orders. They enter into an agreement with a broker where the company commits to buying a certain number of shares over a period based on a specific formula that cannot be changed. Once the agreement is executed, the company loses the ability to influence the decisions anymore.

So, suppose a company had initiated a Rule 10b5-1 trading plan at the starting of the year and committed to buying back shares over the next 5 years. In that case, they can continue to do so even if they have access to non-public material information in the future without worrying about insider trading allegations.

However, the natural disadvantage of using a 10b5-1 trading plan is that the company loses control of the purchases. As a result, some companies may opt to “split” repurchases into a standard plan and a 10b5-1 plan to retain flexibility.

If they have access to non-public information, they can stop their regular buyback plan to avoid any legal issues while continuing buybacks with the 10b5-1 trading plan.

Conclusion 🏁

Now that you’ve made it through this long article entirely, here’s a quick TL;DR to summarize what we covered in this article:

A company can repurchase its own stock as long it follows some regulations. Along with paying dividends, the company can use the buybacks to distribute profits to the shareholders while enjoying other benefits such as better accounting ratios like EPS in the short term. Stock buybacks can be funded by excess cash in the company’s books or financed with debt.

Since the 1980s, there has been an increasing trend of stock buybacks across corporate America, with critics firmly stating that it’s a practice that harms the economy’s long-term growth while prioritizing the short-term gains in share price. Additionally, the incentives for buying back stock might be self-serving for the company’s executives.

As a retail investor, buybacks can be a good or a bad signal depending on the circumstances of the company and the conditions. The practice is widely accepted and shows no sign of stopping in the foreseeable future, especially with the corporate tax cuts in 2017.

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