Stock Buybacks Explained

When the 2017 Tax Cuts and Jobs Act reduced the corporate tax rate from 35% to 21%, the hope was companies would spend their influx of money on expansion and increased jobs and wages. Instead, public companies’ most popular way to spend the excess capital has been to buy back their own stock.1

Stock buybacks can be beneficial to both the corporation and its stockholders. Those selling their stock generally do so at a premium, so they’re happy. Shareholders who retain their stock are also pleased because the same amount of earnings is spread between fewer shares, creating higher earnings per share (EPS). Also, company executives generally buy back stock when they feel the current price, which may well be at a record high, is still below its intrinsic value. They benefit because, in many cases, their bonus is linked to EPS growth.2

Even the best-known investor in the world, Warren Buffett, has said at Berkshire Hathaway’s 2004 annual meeting, “When stock can be bought below a business’s value, it is probably the best use of cash.”3 Buying back stocks is a simple move that can artificially inflate the value of shares without all those complicated expansion plans. However, critics decry the move as masking the true value of a publicly traded business.

Stock buybacks were illegal before the Reagan administration. Legislators believed companies diverting money from employee compensation, research and development would create an income and wealth discrepancy leading to stagnation of the working-class economy.4

The reality is common stockholders don’t have much control over the value of shares. If the price is high, they may want to sell. However, if the company is engaged in a buyback, that could be a clue they expect share prices to go higher, so it may make sense to hang on to shares.

It may be wise to consider why you’d want to sell anyway. Are the proceeds earmarked to pay for a particular financial goal, such as a wedding or college tuition? It’s important to keep your own financial objectives in mind, rather than selling based solely on a company’s dealings. If you find yourself in this situation, we’d be happy to review your portfolio and offer advice within the context of your goals, risk tolerance, and investment timeline.

According to Goldman Sachs, U.S. companies were on track to reach $1 trillion in buybacks in 2018 – a pace nearly double that of 2017.5 Federal Reserve data shows buybacks are now equivalent to 4% of annual economic output.6

Some of the lowest-paying industries have been the most prolific participants in stock buybacks. From 2015 to 2017, the restaurant industry spent 140% of its profits on buybacks (borrowing or dipping into cash allowances to purchase the shares), the retail industry spent nearly 80% of its profits on buybacks, and food-manufacturing firms nearly 60%.7

Despite concerns that buybacks would reduce long-term investment, some companies have been spending capital at the fastest pace in 25 years. Unfortunately, this is not universally true. Goldman Sachs reports 79% of growth in S&P 500 capital spending came from a mere 10 companies.8

Furthermore, S&P 500 firms account for less than 50% of business profits and less than 20% of employment in the United States. A silver lining of buybacks is what shareholders do with the proceeds after selling. A common route is investing in smaller public and private firms, which does more to support innovation and job growth throughout the economy.9