One of the most misunderstood topics in investing is stock buybacks, where corporations use cash to buy back, or retire, their own shares. To the average observer, this seems like simply wasting money that could be reinvested or given to shareholders as dividends. However, nothing could be further from the truth. Buybacks are simply an alternate method to distribute cash to stockholders, and they actually have greater benefits than a dividend. Let’s examine the reasons.

Buybacks Benefit Shareholders

When you own shares, you’re entitled to a certain percentage of future earnings and cash flow. When stock is repurchased, the number of shares outstanding decreases, meaning the Earnings Per Share (EPS) increases. Market price of a stock is determined by two primary factors: 1) Earning Per Share and a 2) Price Multiplier. The Multiplier varies by company and is determined by a number of factors, such as risk and growth.  Market Price = EPS * Multiplier. Let’s look at a simplified example.

Assume a company earns $5000 and has 1000 shares outstanding. EPS = $5000/1000 = $5. if the Multiplier is 20, the Market Price of the stock would be $100. Assume the company wants to distribute all $5 of it’s earnings to shareholders. If this is as a dividend, the stock price and EPS remain the same; thus, the shareholder takes home $5. If, however, the company uses that $5 of earnings to buy back stock, the new EPS would be $5.26 since only 950 shares remain. Assuming the Multiplier remains constant, the new Market Price would be $105.26. In other words, shareholders make more money with a buyback than a dividend. In this example, the stock is now worth $5.26 more, or 26 cents better than the $5 distrubuted in dividends:

Also, because gains aren’t realized until you sell, the investor controls the timing of tax consequences. Dividends usually occur on a regular basis, so you’re taxed as you go year-to-year. With buybacks, the investor can defer the tax on profits, indefinitely if you hold a stock forever. Therefore, instead of flushing cash annually by paying taxes, it is reinvested in the business, compounding the returns. Plus, you can time your sale based on your other income & deduction amounts. In other words, with savvy planning, the investor can reduce the total tax amount paid.

Buybacks Benefit Companies

Once a company starts paying a dividend, they’re expected to pay the same amount or more every year on regular, recurring intervals. This takes away some of the control of their cash deployment. A temporary dip in cash flow may force some unwanted borrowing or the deferral of investment opportunities. Buybacks give companies control over the exact timing of cash deployment. Every quarter they can determine what is the optimal use of the cash. If a great money-making opportunity presents itself, they have the cash to go forward. If not, they can use the cash to pay down debt or buy back their stock. Also, the buybacks provide stock price stability. If their stock price dips, they can buy it back cheaper, which pushes the price back up. If the stock price gets too high, they can hold off on buybacks, which helps bring the price back down to a reasonable level. In other words, the buybacks flatten stock price variances.

Buybacks Benefit Society

As mentioned, with buybacks, companies control the timing, so they have better flexibility in investing. Generally, companies only invest in new projects when the expected return outweighs the weighted cost of capital, which is a fancy way of saying they’ll only invest in a new project if it will earn more than what individual investors can make on their own. Thus, if the company isn’t creating value, they’re better off distributing the cash to owners. And those individual investors can pick’n’choose exactly which investments make the most sense outside that company. Therefore, in an efficient market, societal capital is deployed to the most productive, value-generating opportunities. This is why a low-growth company like Coca-Cola distributes most of its cash to shareholders. The investment opportunities simply aren’t there. On the flipside, fast-growing companies like Nvidia distribute very little of their earnings. In recent years, many investors took money they earned from Coca-Cola buybacks/dividends and bought Nvidia. So, billions were invested in AI technology rather than new soda flavors.

Who Doesn’t Benefit: Government

Tax deferral and timing-optimized selling means less revenue for the politicians, which is why big-government politicians and the media are so vocally attacking stock buybacks & unrealized gains. Buybacks help keep cash deployed in the private sector, rather than be wasted by government. In other words, capital is better deployed to sustain & grow the economy rather than have it flushed on useless wars, campaign contributor kickbacks, inefficient bureaucracies, and other wasteful spending we see year in  and year out.

Conclusion

No system is perfect. Companies sometimes do a poor job on their buyback timing. No one can perfectly predict the future of the economy or stock price levels. Buybacks simply give companies the flexibility to optimize the profits and economic benefits. Banning or overtaxing them simply decreases overall efficiency of the economy and shifts money away from the private sector (where people are rewarded for doing well and punished for doing poorly) to government (where politicians suffer no consequences for their bad decisions and can waste money indefinity). Mathematics and logic tell us buybacks are awesome!

Other Links That May Interest You

Warren Buffett: Stock buyback critics “either economic illiterate or silver-tongued demagogue”

Written By Joe Messerli