When a company engages in stock buybacks, it reclaims ownership previously dispersed among various public and private investors by purchasing its shares at market value. Larger, established firms sometimes acquire shares directly from the market or shareholders and declare stock buyback. Over the last several decades, many corporations have preferred share buybacks over dividends to return cash to shareholders.

Reasons for Stock Buybacks

Companies might initially seem contradictory in buying back shares after going through the effort of selling them to raise capital. Yet, several compelling reasons drive this decision. These include a desire to reduce capital costs, consolidate ownership, stabilize or increase stock prices, address undervaluation, and improve financial ratios. This process is known as a normal-course issuer bid (NCIB) in the Canadian context.

Stock Repurchases and Cost Reduction

Every common stock share represents a fraction of ownership in the company, including voting rights on company policies and financial decisions. For instance, a company with one managing owner and a million shareholders has over a million owners in total. While issuing shares is a common method for raising capital for expansion, a surplus of equity funding without corresponding growth opportunities can be inefficient. It leads to diluted ownership without tangible benefits.

Shareholders typically expect dividends as returns on their investments, which represents a cost to the company. This cost of equity can be burdensome, especially when the funds raised are not effectively utilized. Stock buybacks tax investors and lower the company's cost of capital. In 2016, Walt Disney (DIS) bought back 73.8 million shares for $7.5 billion, lowering its market share.

Stock buybacks serve a strategic role in consolidating ownership within a company. Companies can raise necessary funding for various projects by issuing common and preferred shares. Common shares typically come with voting rights and a slice of ownership, while preferred shares offer dividends before common shareholders and priority during bankruptcy proceedings. However, issuing many shares means having many owners and voters, each with a claim to the company’s capital. A company effectively reduces this number by initiating a buyback and streamlining ownership and decision-making processes.

Preserving Stock Price through Stock Buybacks

Shareholders often seek a continuous dividend increase, aligning with company executives' aim to maximize shareholder wealth. However, this balancing act becomes challenging during economic downturns. Buybacks offer flexibility here. If a recession hits and a company needs to conserve cash, cutting dividends could trigger a sell-off in the stock. Instead, reducing the number of shares bought back can achieve similar financial conservation without as severe an impact on the stock price. Thus, while consistent dividend increases can bolster stock value, buybacks provide a more adaptable tool in uncertain economic times.

Addressing Stock Undervaluation

Another key reason for stock buybacks tax is the perception of undervaluation. This can happen due to investors overlooking a company’s long-term potential, sensational news impacting market sentiment, or a prevailing bearish outlook. The US experienced this after the Great Recession in 2010 and 2011. As stock prices mimicked the last economic fall, companies expecting a return bought back shares. Strategic buybacks banked on price rises when firms recovered.

A corporation may issue 100,000 $25 shares to raise $2.5 million. Negative news might depress the stock price to $15, allowing the business to buyback 50,000 shares for $750,000. In the event of a successful product launch and a stock price increase to $35 per share, reissuing these shares at the higher price may significantly boost equity capital. This strategy lets a corporation capitalize on transitory undervaluation and transform $2.5 million in equity into $3.5 million without issuing additional shares. This approach may scare investors, especially if they feel deceived.

Stock Buybacks Adjust the Financial Statements

Stock buybacks improve a company's financial statements and attract investors. Buybacks may boost EPS by lowering the share count. This rises because fewer shares split the company's yearly profits. EPS is $100 for a corporation with $10 million in yearly profits and 100,000 shares. Despite no profit gain, buying back 10,000 shares would raise EPS to $111.11.

Short-term investors may invest in a firm before a buyback stock to enhance its value and P/E. Buybacks also boost ROE. A repurchase is seen as an indication of the company's financial strength and management's willingness to reinvest. Share buybacks are safer than new technology development or firm acquisitions. They imply future stock gain, which attracts investors if the firm grows.

Downsides of Stock Buybacks

Stock buybacks have, however, some negatives. If a company borrows money to finance these buybacks, it may hurt its credit rating. Loan interest, although tax-deductible, increases the company's debt burden and depletes cash resources, which may be required in periods of economic hardship.

Credit rating agencies usually negatively perceive stock buybacks financed with debt because they do not believe that increasing EPS or capitalizing on shares, which are undervalued, to begin with, should justify the insurgence in company debts. Such a strategy may see a company’s credit rating downgraded. Furthermore, as of January 2023, stock buybacks by publicly traded firms will attract a 1% excise tax in cases where the repurchases do not surmount $1 million or if such activities are conducted without offsetting with shares offered to the public through new issuance or issued to employees.

Stock Repurchase and the Economy

While stock repurchases might benefit some individual companies, their impact on the overall economy is far more complicated. Generally speaking, they have a mildly positive effect on the economy by directly influencing financial markets resulting in increased stock prices. In turn, the stock market affects the real economy. For instance, studies suggest that stock market profits can increase consumer confidence and spending, known as “the wealth effect.”

Improvements in financial markets can also lower the costs of borrowing for corporations, leading them to increase operations or invest in research and development. These activities can also increase employment and income, improving household balance sheets. In addition, they can enhance consumers’ capability to take credit for substantial acquisitions such as homes or business beginnings, thus creating more economic activity.