Before the 1980s, corporations rarely repurchased shares of their own stock. Today, stock buybacks are a global phenomenon. In 2018 alone, companies in the S&P 500 Index spent a combined $806 billion in buybacks, about $200 billion more than the previous record set in 2007.
While it’s true that stock buybacks fell by 29% last year during the pandemic, experts expect stock buybacks to boom in 2022. Indeed, the first quarter of 2021 already saw companies buying back their stock at pre-pandemic levels.
But why would a company buy back its own stocks? Are stock buybacks good for the economy? And most importantly, who benefits when a company repurchases its own shares?
Here, we’ll explain what a stock buyback is — and why you should care.
What is a stock buyback? Why would a company buy back its own stock?
A stock buyback occurs when a company buys back its own shares from the stock market. Sometimes the buyback can benefit shareholders, as an efficient way to return capital.
At its core, the stock buyback is a simple concept. A company strives to make money throughout the year. Generally, this means they produce free cash flow. This is the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. As a company makes money, they face a decision. When they have excess capital, what should they do with these extra funds? The company can generally do one or more of the following four options:
- They can make capital expenditures, which are investments that a company makes to grow their business operations; for example, buying a new machine or building.
- They can acquire another company or business unit.
- They can pay cash dividends to the shareholders.
- They can use the money to repurchase their shares—a stock buyback.
Stock buybacks are a huge value driver for businesses. In August, Goldman Sachs analyst David Kostin said that the more than $720B he estimated companies would commit to buybacks would help push the S&P 500 up an additional 5% before the end of the year (from his lips to God’s ears).
Because of how meaningful stock buybacks can be, there is even an S&P 500 Buyback Index which tracks the top 100 companies in the S&P 500 with the highest buyback ratio (cash paid to buy back common shares / market capitalization).
Are stock buybacks good for investors?
As with many things in finance, the answer is, “it depends.” If a company sees its shares as undervalued and has excess capital, which will not be used to pursue accretive projects, then a buyback could be a fantastic way to generate shareholder value.
After a share buyback, shareholders will own a bigger portion of the company, and therefore a bigger portion of its earnings. In theory, a company will pursue stock buybacks because they offer the best potential return for shareholders – more than they would get from doing any of the other three options listed above. (Consider it a good sign if top managers at the company are also buying company stock for themselves.)
Stock buybacks are also relatively low risk compared to some of the other approaches for spending excess cash, like expanding business operations or reinvesting that money, say, into a new product or technology.
Do stock buybacks help the economy?
Stock buybacks aren’t always a good thing. If a company’s shares are expensive, it might be worthwhile to ask why the company is repurchasing its stock instead of paying a special dividend. A recent Harvard Business Review article suggests stock buybacks are bad for the economy, resulting in soaring corporate debt and financial risk-taking.
“Why have U.S. companies done these massive buybacks? With the majority of their compensation coming from stock options and stock awards, senior corporate executives have used open-market repurchases to manipulate their companies’ stock prices to their own benefit and that of others who are in the business of timing the buying and selling of publicly listed shares.”
Some experts claim stock buybacks may increase income inequality, employment instability and reduce productivity overall, encouraging a boom-and-bust economy. There have even been calls for open-market stock buybacks to be banned.
So the next time a company announces a stock buyback, ask yourself: Are they signaling that their shares are cheap – or is something else at play?
Stock buybacks vs. long-term value
The root cause of the stock buyback problem isn’t so much that companies sometimes choose to buy back their own shares, but rather, that they prioritize short-term pay schemes over long-term thinking and opt for stock buybacks in lieu of innovation.
When companies have excess capital to spend and growth opportunities are poor, a stock buyback can be a smart financial decision. The tricky part is making sure managers and CEOs focus on sustainable, long-term growth, instead of boosting stock prices (and lining their pockets) at their shareholders’ expense.