What Is a Stock Buyback?

The first Trump administration cut the U.S. corporate tax rate to 21% from 35% in 2017, catalyzing a significant surge in stock buybacks by publicly traded companies.

The total number participating during any given quarter can vary, but public companies continue to make use of stock buybacks to return money to their investors.

During the second quarter, stock buybacks among the S&P 500 totaled $235.9 billion, a year-over-year increase of 34.9%. And total volume is on track to surpass the record $1.2 trillion in stock buybacks reported in 2023.

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But what is a stock buyback? And why would a publicly traded company choose a stock buyback instead of using the available funds to support a new or an increased dividend?

Indeed, why would a company choose a stock buyback rather than investing in the growth of its business?

How does a stock buyback work?

When a public company announces a share repurchase program, it usually specifies the total dollar figure it will spend buying back its own stock in the market.

That means dealing with willing shareholders selling their stock in the company through open market operations. These sellers have no way of knowing who their buyer is, whether or not it's a company repurchasing its own shares.

It's not common for a company to announce the number of shares it plans to buy back. Expressing its intent with a dollar figure takes account of the unpredictability of price action in the open market.

Take Wells Fargo (WFC), which announced in mid-2023 that its board of directors approved a new $30 billion share repurchase program.

By giving a dollar amount, the company is able to gauge market conditions and decide whether the stock price on any particular day is in the target range of what they will pay.

Once the company buys the shares, it generally cancels them, thereby reducing the total number of shares outstanding. Then, at the end of the quarter, it will announce how many shares were bought and the average price paid.

Why would a company buy back shares? 

"What is a stock buyback?" is an interesting question. Another interesting question is, "Why would a company buy its own stock?"

Here are three reasons why a publicly traded company would announce a stock buyback.

Sterilization. One major purpose of buybacks is sterilization, which is the cancellation of shares that are otherwise issued to employees when their stock options or restricted stock rewards and benefits are issued.

In other words, the total number of shares does not increase, as the buybacks sterilize the normal growth in share growth.

Leverage. A second reason companies buy back shares is to effect a change in the stock price. This force effect occurs along two lines.

First, all the share buyback activity provides a natural buyer in the market that keeps the price elevated. Second, the stock can rise as the calculation of earnings per share rises. With less shares outstanding, the earnings divided by the average share count each goes up. 

So, assuming the market rates the company with the same price-to-earnings multiple, the stock price will tend to rise over time.

Efficient return. A third and even more important reason for stock buybacks is the tax efficient way it returns capital to investors.

The simplest way to understand this is the fact that over time, a company that does stock buybacks can significantly increase its dividends per share. This is also done without increasing the cost of the dividends to the company.

In effect, the payments that otherwise would be used for dividend increases are spent buying back stock. So, with fewer shares outstanding, the normal dividend will rise on a per-share basis.

We can also compare results of a company that buys back its shares to results of a company that doesn't buy back shares but increases its dividend instead. The after-tax return to the buyback shareholders is always greater.

I've written extensively about this "buyback yield" effect. My calculations show that a person who owns stock in a company that raises its dividend but does not buy back shares will pay more income tax.

Moreover, all things being equal, dividends per share will not rise and neither will the stock price. So shareholders have a limited return.

But the company that buys back its shares will produce a higher stock price because as its shares count falls, it forces the price higher. This assumes the market valuation stays level and all other things are equal. Moreover, that effect produces more value for shareholders, as they pay no taxes on this unrealized gain (until they sell shares).

In effect, buyback companies help their shareholders by efficiently returning capital to them. This is mainly by avoiding double taxation of the money otherwise spent on dividend payments.

Is a stock buyback a good thing?

The Inflation Reduction Act of 2022 included language that imposed a 1.0% tax on buybacks. The Biden administration aimed to raise that tax substantially, on the belief that buybacks limit public companies' spending on corporate initiatives that will benefit all its stakeholders, not just shareholders.

Donald Trump's victory in the 2024 U.S. presidential election means that tax increase won't happen. However, the criticism that buybacks hinder corporate investment remains. Many disagree with it.

That includes Warren Buffett, who famously wrote in his 2022 letter to Berkshire Hathaway (BRK.B) shareholders that buyback detractors are either "economically illiterate or a silver-tongued demagogue (characters that are not mutually exclusive)."

Another criticism is that buybacks only work to the benefit of shareholders if prices are stable or falling. Some companies have been criticized for buying back shares at market peaks. After all, that means the company may have overpaid, especially if the stock never recovers.

However, the vast majority of companies that buy back shares have benefited from share repurchases even as their stock price is rising.

After all, since buybacks are so popular with investors, it actually has had an ancillary leverage effect. Buybacks, both from the market effect and the leverage effect, tend to push up stock prices. Companies now assume that they will have to keep buying shares at higher and higher prices.

But perhaps the best rebuttal of buyback criticism is the fact that almost all companies that pursue large buybacks have free cash flow (FCF). This means that all the buyback money is "free" to be spent after all expenses and capital expenditures have already been deducted from operating cash flow.

The bottom line is that buybacks tend to work to the benefit of all shareholders, as Warren Buffett pronounced in his 2022 shareholder letter.

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