Stock Buybacks Explained

The benefits, drawbacks, and controversies...

Apr 04, 2024

👋🏼 everyone,

In recent weeks, Goldman Sachs said it expects U.S. share buybacks to exceed $1 trillion for the first time in 2025, driven by strong earnings growth from technology companies and looser financial conditions as the Federal Reserve looks to cut interest rates.

But what implications does this have for the average person? Should we be cautious about companies repurchasing their stock? And how does this affect the stocks that investors own in these companies?

Buybacks are certainly not without controversy. This tweet from Bernie Sanders discussing the Chevron buyback last year, is an opinion held by many.

With that in mind, let's explore the positive, negative and controversial aspects of stock buybacks!

Today I’ll cover:

Stock buybacks - quickly explained 📜
The Upsides 😀
The Downsides 🧐
📹 A simple buyback case study using Amazon’s $10 billion buyback
A list of companies buying back shares in 2024 👀

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(Quickly) Explained…

OK, so imagine a company's got some extra cash lying around. Instead of just letting it sit there, they can do a few things with it. One option is a stock buyback.

Here's how it works: the company decides to buy back some of its own shares from the stock market. It's like saying, "Hey, we think our company is pretty awesome, so we'll buy our own shares because we believe they're undervalued or we just want fewer shares out there."

So, they start buying up their own stock from investors who are willing to sell. As they buy, the total number of shares available to the public decreases, which means each remaining share represents a bigger piece of the company.

This can be good for existing shareholders as it might boost the value of their shares since the company's dividing its profits among fewer shares. Plus, it's a way for the company to show confidence in itself.

But critics sometimes say it's not always the best move. They argue that instead of doing buybacks, the company could use that money for other things like investing in research, expanding, or even giving it back to shareholders through dividends.

When circling back to the question of why companies undertake stock buybacks, this is where things can start to get a bit hazy, depending on who you ask.

The Upsides 😀

The primary (and typical) reason a company undertakes a stock buyback is pretty straightforward: they want to boost the value of their shares.

A company usually pulls this move when their shares are taking a beating or just haven't been doing so great lately. The company figures its stock is worth more than what folks are paying for it out there. So, they jump in to scoop up their own shares, aiming to shoot up the stock price by boosting the earnings per share (EPS).

It's like financial tinkering 101, and the math is pretty simple:

Let's take Company X, for example. They've got 100 million shares out in the markets and take in $300 million in profits. That means each share's earnings come out to $3.

Now, say Company X throws some cash at buying back 10 million shares. If they still make the same $300 million, the new EPS calculation looks like this:

$300 million divided by 90 million shares equals $3.33 per share.

By shrinking the number of shares out there, they're giving a little boost to their EPS.

Now, let's take it a step further. If the market usually slaps a 20X multiple on Company X's shares, before the buyback, they'd be trading at $60. But after the buyback? You're looking at $66.67.

So, Company X throws down some cash to buy its stock, and suddenly, shareholders are seeing a nicer price tag per share. Not a bad deal, I’d say!

Especially when you compare it to dishing out a dividend to shareholders.

Why?

Because dividends get taxed as regular income when you get them. With buybacks, you can put off paying those capital gains taxes until you actually sell your shares.

The downsides 🧐

Buybacks often get linked to behaviors that end up harming long-term value, like personal gain schemes, bad timing on investments, and loading up on too much debt.

Even though buybacks might seem like a tempting way to give cash back to shareholders, they can be a risky move that leads to big problems down the line.

Executive compensation gaming 🫣

One common gripe is that management might use buybacks to play with earnings per share (EPS), which helps them hit their own bonus targets and meet quarterly goals.

In fact, back in 2019, more than 30 percent of compensation plans were tied to EPS.

Employee trading 🕵🏼

Even though there are rules to stop employee trading, people have found ways to get around them, especially in the US. For example, while employees can't trade on the same day as a buyback announcement, executives can announce a buyback and then sell their shares a few days later.

A study by the SEC in 2018 found that insiders were twice as likely to sell shares after a buyback announcement compared to before it. This trend led to lower stock returns in the long run, especially in companies where insiders sold a lot.

Interestingly, outside the US, there's not much evidence of employee stock manipulation.

In places like the UK and Japan, rules require all employee transactions to be reported by the next day, and employees can't trade in the weeks or months leading up to certain periods. So, employee trading like this just isn't possible under these strict regulations.

Poor timing of investment decisions

Management teams often say they like to buy their stock when it is undervalued, but companies do a poor job of timing the market, often buying at market peaks rather than troughs. Two factors contribute to this tendency:

Firstly, managers often grapple with an overconfidence bias. Just like when you ask a hundred people if they're better than average drivers and 80% claim they are!

Similarly, executives tend to think their company is undervalued, believing they've got the Midas touch to boost its worth. This inflated confidence leads them to see share buybacks at current valuation levels as a smart move.

Secondly, companies usually jump on the share buyback bandwagon when they're riding high, flush with cash and feeling like kings of the hill. It's like they're buying stocks when they're already peaking, which, from an investment standpoint, is a bit of a head-scratcher. After all, the golden rule is to buy low and sell high?! Yet, it's rare to see a company announce a buyback program when the market's in the dumps.

A simple buyback case study using Amazon’s $10 billion buyback

Companies buying back shares in 2024 🤑

Here a list of all the companies who’ve announced they’ll be undertaking share buybacks in 2024.

And that’s it! I hope you feel a little bit more knowledgable about stock buybacks and the various strategies behind them.

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