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If you follow the stock market closely, you may have encountered the term “buybacks.” This article explains what buybacks are, who is involved, and their impact on the stock market.
Understanding Buybacks
A stock buyback, also known as a share repurchase, refers to a company buying its own shares from the market. Shares can be repurchased in two main ways: in the open market or through a tender offer.
In a tender offer, the company offers existing shareholders the opportunity to sell some or all of their shares back to the company within a specific timeframe, usually at a premium above the current market price. This premium encourages investors to sell sooner than planned.
When a company opts to buy back shares in the open market, it often indicates a long-term strategy, sometimes outlined in a buyback program. Companies may even issue debt to fund these repurchases.
After the buyback occurs, the shares are retired since a company cannot hold shares as a shareholder. This has two main effects: it reduces the total number of shares in circulation and increases the relative ownership stake of remaining shareholders. Consequently, each investor’s share of the company’s cash flow and earnings rises, leading to an increase in earnings per share (EPS).
Reasons for Share Buybacks
Companies typically engage in buybacks as a way to reinvest in themselves or return excess cash to investors. By reducing the number of shares, buybacks can boost share prices and enhance shareholder value. Many investors view buybacks positively, as they reflect strong free cash flow and a belief that the company’s stock is undervalued.
Some investors might prefer buybacks over dividends because they offer tax advantages. In certain cases, buybacks can be taxed as capital gains, which often has lower tax rates compared to the taxation of dividend income.
Additionally, companies may repurchase shares to meet employee compensation plans, especially if employees have been granted shares, while avoiding the dilution of existing shares.
However, investors should be cautious about companies that use buybacks to artificially inflate stock prices or earnings, particularly if executives’ compensation is closely tied to performance metrics that can be manipulated. The short-term effects of buybacks can sometimes mask the need for sustainable growth strategies.
The Impact of Buybacks on Market Prices
Buybacks provide valuable support to stock markets. When prices decline, it may become more attractive for companies to repurchase their own shares. This action can provide liquidity and stabilize share prices when the market is under pressure.
In the past decade, buybacks have shown a pattern where the corporate sector has emerged as a significant net buyer of shares. For example, in the third quarter of 2018, U.S. companies initiated record levels of buybacks, which had been on the rise since the financial crisis. Total announced buybacks exceeded $1 trillion before the year’s end.
The tax cuts implemented in early 2018 fueled buybacks by lowering tax rates and providing tax breaks for repatriating overseas profits, resulting in cash windfalls for some companies. Tech giants contributed significantly to buyback activity, accounting for roughly 25% of the total market in 2017, with notable examples like Apple announcing buybacks of $100 billion in 2018.
The first financial quarter often sees a spike in buyback announcements as companies strategize for the upcoming year and finalize budgets. Given the sharp decline in global stock markets towards the end of 2018, combined with robust U.S. corporate balance sheets, we expect a wave of buybacks to be announced in the near future.
Risk Warning
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