Stock Buybacks: Examples, Definition & Benefits

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Stock Buybacks: Examples, Definition & Benefits

Updated on August 16th, 2021 by Bob Ciura

Stock buybacks are a popular (yet misunderstood) way for a corporation to return cash to shareholders.

The misunderstanding surrounding stock buybacks is unfortunate. Many investors analyze a variety of financial ratios and metrics, but fail to look at share repurchases.

A definition of stock buybacks is below:

Stock buybacks (also called share repurchases or stock repurchases) are when a publicly traded business uses cash to buy back some of its outstanding shares.

Stock buybacks reduce the amount of shares outstanding. This is good for the remaining shareholders.

An example is below.

Video Analysis

The following video provides a detailed analysis on share repurchases, including two examples on how they can build shareholder value over time.

Keep reading to learn more about the powerful implications that share repurchases can have on long-term investing outcomes.

Stock Buybacks Example

Imagine a business makes $1,000,000 a year in profits and has 10 partners who each own 10% of the business. This business pays out 50% of its profits every year to its owners. Each owner gets $50,000 a year.

Now imagine that one of the partners wants to ‘cash out’. Everyone agrees the business is worth $10,000,000 (a 10x earnings multiple).  The business spends $1,000,000 in excess cash to buy out a partner.

After the buyout, the business is still making $1,000,000 per year and paying out half of that money to its 9 remaining owners. The only difference is that now each owner now owns 11.1% of the business because one of the owners was bought out.

Instead of receiving $50,000 a year, the remaining 9 owners will receive $55,556 a year even though the business did not grow. What did grow is the percentage of ownership of each remaining member of the business.

Stock Buybacks & Ownership

The ultimate goal of rational shareholders is to maximize the per share value of the business. Stock buybacks can increase per share value by reducing the number of shares outstanding.

Said another way, share repurchases increase your percentage ownership in a business. The table below shows how hypothetical business with a price-to-earnings ratio of 15 that uses 75% of its earnings on share buybacks.

If you owned 1% of the business initially, the table below shows how much your ownership would increase over time because of share repurchases alone.

Share Buyback Ownership Table

After 30 years, your ownership in the business (and claim on income) would have more than quadrupled, even if the business did not grow at all.

When a growing business repurchases shares, you get very interesting results.

The table below shows the amazing compounding power of a business that:


Share Buybacks With Growth

After 30 years you would have 21.79x your initial investment. Not bad for a business growing at ‘just’ 5% a year.

The trick is that the business was very shareholder friendly and allocated capital very well.  It is also important that the hypothetical business above stayed reasonably cheap the entire time.

Share repurchases are similar in that money is returned to shareholders, although not directly.

Stock Buybacks, Dividends, & Taxes

If taxes didn’t exist, the effects of stock buybacks would be identical to the effects of reinvesting dividends.

In a tax-free environment, dividends are preferable to share buybacks. Dividends give you the options of:

  1. Reinvesting back into the company (exactly the same as a share repurchase)
  2. Buying stock in a different business with the dividend payment
  3. Spending the dividend on whatever else you’d like

Unfortunately, we do not live in a tax-free world. Think of all the taxes a dividend has to go through before it reaches you:

  1. You are taxed on the income you earned to invest in the stock market
  2. The corporation is taxed on income it made to pay the dividend
  3. Your dividend payment itself is taxed

Are stock buybacks or dividends better for shareholders? It depends on the situation. Qualified dividends are taxed at between 0% and 20% in the United States for taxable accounts.

Dividend payments are taxed, while stock buybacks are not. This makes share repurchases a more tax efficient vehicle for returning capital to shareholders than dividends.

Maybe that’s why the dividend payout ratio has fallen over time, from 55% in the mid-1960’s to the current level of ~30%-40%. And share repurchases have only grown. In fact, S&P 500 Index companies now spend more on stock buybacks than on dividends.

Source: PR Newswire

Tax consequences reduce the value of dividends. Share repurchases do not suffer from the same taxation weakness. Shareholders reap the benefits of share repurchases without incurring any taxes at the time of the repurchase.

Of course, share repurchases really are taxed if one includes capital gains taxes. Another simple example will illustrate this point:

Imagine a corporation’s stock is trading at $50 a share. It has 20 million shares outstanding. If the corporation were to somehow repurchase 10 million of its shares outstanding, the company’s stock price would rise to $100 a share all other things being equal. If an investor then sold their shares, they would incur a long-term capital gains tax rate of between 0% and 23.8% on their gains.

All of the gains in the example above were a result of share repurchases. When one sells their stock, they will have to pay the same tax rate on their gains from share repurchases as they would on their gains from dividends.

Share repurchases do have one tax advantage over dividends. With share repurchases, you do not have to pay your taxes upfront. Instead, you get to keep the money you would have to pay in taxes compounding in the business. Dividends – even when reinvested – trigger a taxable event. Share repurchases do not.

In reality, most businesses do not pay either dividends or repurchase shares, they do both. There are many Dividend Aristocrats that not only have excellent streaks of rising dividends, but also regularly repurchase large amounts of shares.

Stock Buybacks & Management Incentives

Corporations often reward their C-level executives with incentive packages. These incentive packages are often based on a stock hitting a certain price…

There is no easier way to ‘game’ this system than to repurchase shares.

You may be thinking “that’s fine, this just aligns management and shareholder incentives. After all, shareholders benefit from share repurchases”.

The truth is, stock buybacks can destroy shareholder value.

If shares are repurchased when a stock is trading above its intrinsic/fair value, management is effectively spending $1 to buy less than $1 in value. This is not good.

When a stock is overvalued, it is far better for management to return cash to shareholders through dividends rather than share repurchases.

If a stock is significantly overvalued, it would actually be beneficial for management to issue shares and return the proceeds to investors as dividends. Sadly, I know of no examples of this occurring in the real world.

Unfortunately, management is incentivized to destroy shareholder value by repurchasing shares when the stock price is overvalued. In fact, aggregate share repurchases in the S&P 500 Index tend to peak when the index is at its highest point in a market cycle – which is the opposite of what should be happening if management teams were completely rational (a silly assumption).

Just because share repurchases are occurring, this does not mean that a company’s management has the shareholders’ best interest in mind.

Management should be rewarded based on the long-term, per-share total returns of its stock.  There’s no better way for management’s interests to be aligned with shareholders than for management to hold large amount of company stock (not options).

In many of the examples above I assumed that share repurchases were funded with earnings.  This is often not the case.

Stock Buybacks & Debt

Share repurchases are often funded through debt issuance and not from a company’s earnings.

Source: Plan Financial

Being able to borrow money should not be the prime criteria for share repurchases. Should businesses use debt to finance share repurchases? It depends on the situation.

As discussed earlier in this article, if a stock is overvalued, shares should not be repurchased – regardless of how repurchases are financed. Using debt to repurchase overvalued shares is even worse than using cash to do so. It’s like taking out a loan to buy 3 quarters for one dollar.

Debt Share Repurchases

The first criteria for using debt to repurchase shares is the company’s stock must be undervalued.

If this criteria is met, then things become more interesting…

In some cases, a business can issue bonds with interest rates lower than its stock’s dividend yield.

In these cases, debt fueled share repurchases are very beneficial. They reduce the amount of shares outstanding and reduce the company’s future cash flow obligations.

As an example, if a stock has a 5% dividend yield and can issue debt with 4% interest, issuing debt and repurchasing shares will reduce cash outflows by 1% while simultaneously increasing shareholder ownership. This is a win-win situation.

On top of this, interest payments are tax deductible, while dividend payments are not.

If a company’s shares are undervalued, issuing debt to finance share repurchases can be good for shareholders if the company has highly stable cash flows.

Too much leverage has destroyed many a business as the Warren Buffett quote below emphasized:

“I’ve seen more people fail because of liquor and leverage – leverage being borrowed money. You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.”

Corporations tend to over-leverage themselves during the ‘good times’, and then run into trouble during recessions when their profits fall (but they still have to make debt payments).

Companies with excess debt loads already, or companies that perform poorly during recessions should not use debt to repurchase shares. Highly stable businesses will likely realize greater total returns by commencing on debt funded share repurchases when the stock is trading below fair value.

Do Buybacks Mean A Company Is Out of Growth Options?

One common misconception about stock buybacks is that they mean a company is out of growth options. This is not the case.

If a company’s stock is undervalued, stock buybacks are often the best use of capital, even when there are other profitable growth opportunities available.

Imagine a stock is undervalued by around 20%. Repurchasing shares immediately generates a return on investment of 20%.

If a company has growth opportunities that could provide 15% return on investment a year, it would be unwise to fund them while the stock is undervalued. Stock buybacks are the proper choice in this case.

If a company’s stock is overvalued, then the opposite is true.

Share issuances are not always a bad thing.  If you believe the intrinsic value of your company’s stock is around $100 a share, and the market price is $150 a share, issuing stock is an excellent source of capital, as long as you have profitable growth opportunities in which to invest.

Final Thoughts

Share buybacks are, on average, beneficial for shareholders. The very best capital allocators will only repurchase shares when their stock price is trading below fair value.

When a stock is trading above fair value, dividends are a far better way to return cash to shareholders.

High quality blue chip dividend stocks with stable cash flows that are also undervalued make good candidates for share repurchases.

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