Capital Investment Advisors

Corporate Stock Buybacks: What They Are And How They Work

Voiced by Amazon Polly

Corporate buybacks get a bad rap, and it is typically undeserved. Critics’ say this business practice is designed to enrich CEOs at the expense of the investor. I beg to differ. Rather than being shuffled to the side, investors often could stand to reap significant benefits when a company buys back shares of its own stock.

Buybacks don’t always equal corporate greed – that sentiment is a misunderstood stereotype. They typically equal investment in the company’s growth, innovation, and future. The charge that S&P 500 shareholder payouts are starving the U.S. economy of investment doesn’t pass the litmus test when weighed against the real data.

Before we look at the numbers, an explanation of what corporate buybacks are and how they’re beneficial will be useful.

In recent years, companies have employed a corporate buyback strategy – meaning a corporation will “buy back” shares of stock that the company issued initially. In practice, the issuing company will pay its shareholders market price for shares. This purchasing happens on the open market or from the shareholders directly. The corporation then re-absorbs those pieces of its ownership.

To be clear, the vast majority of the time, companies aren’t buying back shares on borrowed money – they do so with their current cash. The more profitable a company, the more shares they can afford to buy back.

By definition, stock repurchasing allows companies to reinvest in themselves by reducing the number of outstanding shares on the market. There are a few key reasons why a company would use this strategy.

Principally, this practice reduces the numbers of outstanding shares while maintaining the same amount of earnings (before further growth happens), increasing earnings per share. For investors who choose to hold onto their stocks in the company, they have a higher percentage of ownership in the company and a higher price per share. And, a shareholder’s total value in a corporation equals their dividends plus the share buybacks.

Just taking the two factors of increased percentage ownership and higher earnings for share, you can see the appeal of corporate buybacks.

Companies like to replenish their working capital. Greater assets mean the companies look more financially healthy, thereby attracting more investors. And they don’t typically just hold the money in a cache – these businesses use it for things like research and development and innovation to grow their value.

“Boeing has won in the marketplace for 100 years because of innovation, and we need to continue to invest in innovation for the future,” said Boeing CEO Dennis Muilenburg on the topic of corporate buybacks. And he’s not alone.

Also, when companies buy back stock from shareholders, they are often able to sell new stock directly to investors or grant equity to the corporation’s employees who decide to sell the shares to investors. Other reasons for corporate buybacks are to empower companies to consolidate ownership, and, when there’s pessimism surrounding the market, to increase the corporation’s equity value.

Corporate buybacks are overall generally a net positive for investors. Considered another way, companies can either pay investors a dividend as a value return, or buy back shares, increasing investors’ ownership percentage.

Looking to the data, it’s telling to examine how the most massive stock buyback companies have performed. Our numbers come from Federal Reserve’s Flow of Funds Accounts, which employs over 300 Ph.D. economists. In 2018, corporate buybacks accounted for $573 billion in net new demand for equities.

And, since 1994, when the strategy gained significant traction, the S&P 500 averaged 9.6% per annum. During the same period, the S&P Buyback Index averaged 12.5%. Looking back over the past 25 or so years, it can’t be mere coincidence that these corporations have outperformed the overall market.

When companies aggressively buy back their stock, it’s a gain for the shares (and shareholders). What this does is indicate that the corporation has the assets to make the buy back, and for investors, it increases overall shareholder yield. I believe that overall, stock dividends plus share buybacks are metrics we can’t ignore. They signal a favorable market, not a flailing one.

Amazon CEO Jeff Bezos captures corporate buybacks succinctly: “It’s all about the long term.” And doesn’t that ring a bell for every investor?

Previous ArticleNext Article