Stock Buybacks Explained

PUBLISHED Jun 22, 2022, 3:12:38 PM        SHARE

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There's no denying that it's a rough time for the stock market. With many predicting a recession followed by a lengthy recovery, investors need every tool at their fingertips. When trying to decide where to invest your money, you may have come across the term stock buyback. What is a stock buyback, and can it raise the share price?

What is a Stock Buyback?

Most people know that corporations sell shares of stock to raise money. However, fewer might be aware that many corporations later buy back a lot of these shares! This may seem counterintuitive - why would a company that sold shares of stock to raise money want to spend money to buy those shares back?

Why Corporations Buy Back Stock

Corporations repurchase their own shares for a few key reasons, the biggest being that it raises the share price. This keeps investors happy and makes the corporation appear highly profitable. Also, it benefits corporate employees and executives who have stock options or have otherwise heavily invested in the company's shares themselves.

Secondly, stock buybacks boost corporations' financial statements, especially earnings per share (EPS). With fewer shares of stock outstanding, this increases EPS by dividing the firm's profit (income minus expenditures minus dividends paid) among fewer shares. In addition to helping raise the share price directly, buybacks attract further demand for shares by raising the EPS.

Third, stock buybacks reduce the amount of dividends the corporation must pay. While corporations can simply suspend dividends, this can be very unpopular with investors. To reduce the dividends they pay, corporations can simply have fewer outstanding shares upon which they must pay dividends. Additionally, dividends may be less popular than rising share prices for investors because dividend payments are taxed as income. When shares of stock are sold for a profit, however, the profit is taxed as a capital gain, which is taxed at a lower rate than earned income.

So, Who is Buying Back Their Stock?

Several widely-known corporations are big on buybacks. In fact, many stockbrokers even have portfolios dedicated to buyback leaders, as these corporations tend to have steady stock performance. Currently, Procter & Gamble, Sherwin-Williams, Target, Apple, Union Pacific, and NXP Semiconductors are considered big buyback leaders, which may help buoy their share prices through an upcoming minor recession. If you're looking for some diversification by picking up stocks in those respective industries (consumer staples, home improvement, retail, tech, and transportation), it may be wise to go with a buyback leader versus a similar substitute that does not play the buyback game.

Buybacks are Good, but Watch the News

Stock buybacks raise share prices, benefiting those who have invested in those firms. But, there is plenty of controversy! Buybacks have been criticized for creating the appearance of corporate profits, misleading the public. They have also been considered a misuse of corporate tax cuts, which were intended to boost worker pay or investment in new capital. And some buybacks are "artificial" because they do not reduce share count over the long term - the corporation floats new shares. Thus, buybacks from firms that routinely sell new shares could be considered "churning."

Because of the controversy around stock buybacks, there is the possibility that Congress, especially under Democratic Party control, could pass new legislation to limit the practice. If you invest heavily in firms that are buyback leaders, this legislation could impact share price. Always stay up-to-date on financial, economic, and investing news!

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