What are Stock Buybacks?

Are stock buybacks good for investors?

Stock buybacks can be appealing to investors in a handful of different scenarios. In one common instance, they can be a signal that a company has excess cash on hand, giving shareholders reassurance with regard to the company’s cashflow status.

"For starters, they’re a sign that the company won’t be doing something wasteful with that excess cash — like making an unwise acquisition or expanding too rapidly — and some investors feel they’re a good sign overall," Capital Asset Management President and CEO John E. Girouard wrote in an article for Forbes.

"For example, many investors’ first instinct on buybacks is, 'Oh, this company must know something good is about to happen, and thus they want more profit for themselves.'"

Alongside the idea that good things are to come is the share price boost that buybacks can provide. If a company feels its shares are undervalued, it may buy them back and then resell them in the open market after it sees a share price improvement. This type of improvement is generally the result of simple supply and demand.

Can stock buybacks have a negative impact?

As with most things, there is a dark side to stock buybacks. Critics point out that the excess cash used to buy back shares should actually be reinvested to facilitate job creation and infrastructure upgrades.

Investopedia has identified three negative impacts of stock buybacks:

• They can “give an artificial lift to the stock and mask financial problems."
• They allow executives to take advantage of stock option programs while not diluting earnings per share.
• They can create a short-term share price bump that may allow insiders to profit at the expense of investors.

Dryden Pence, chief investment officer of Pence Wealth Management, told Forbes that stock buybacks can also be harmful to companies because they can hamper their ability to ride out a financial storm.

Citing airlines as an example, Pence said that over the last decade, major US airlines spent 96 percent of their free cashflow on buybacks, hence why these same airlines needed US$54 billion in government bailouts during the COVID-19 crisis.

The potential negative impact on the economy as a whole prompted Democrats in the US to include a 2 percent excise tax on stock buybacks as part of the corporate tax proposals included in the country's 2022 budget bill. A survey conducted by the CNBC Global CFO Council indicated that 55 percent of US CFOs believed such a tax would curtail their buyback activities.

The 2 percent excise tax proposal eventually died along with the Build Back Better Plan. A 1 percent excise tax was later included Biden's Inflation Reduction Act, which took effect in 2023.

What questions to ask when a stock buyback occurs?

When a company institutes a buyback program, shareholders should ask themselves why it is occurring. Is the company changing direction? Does it need to increase its earnings per share? Is a share repurchase a way to regain equity, and therefore control?

It’s important to consider these questions, as the answers can determine whether it is prudent to hold on to a stock, or whether it’s better to take the buyback being offered. Share buybacks can also give insight into how a company is functioning overall, which is important when making investment decisions in general and can help when getting a feel for a company’s industry and field.

In any case, investors should weigh all options and driving factors in order to make the best decision when a buyback is offered.