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There is something peculiar happening in the US stock market. Listed US companies are using up their cash reserve, not to fund expansion or growth, but to buy back their own shares.
In 2024, S&P 500 companies spent $942.5 billion on share buyback programs, up from $795 billion in 2023. Citi and Goldman analysts predict that this could surpass $1 trillion by the end of 2025, marking a record-breaking trend in capital return strategies.
So, what is driving this surge in US stock buybacks? And, more importantly, how stock buybacks affect stock price. In this article, we will dive deep into the benefits of stock buybacks and the impact of share buybacks on stock volatility.
What are Share Buybacks and Why do Companies Use Them?
A stock buyback occurs when a company uses its cash reserve to purchase its shares from the open market. There are several strategic motives for companies to announce share buybacks:
Return on Capital to Shareholders: Like dividends, buybacks are a way to return excess cash to investors. Companies announce buybacks, especially when they believe reinvestment opportunities within the business are limited.
Signal Undervaluation: Companies may view their shares as undervalued and use buybacks as an opportunity to signal confidence to the market about their strong future growth potential.
Boost Earnings Per Share (EPS): EPS is calculated by dividing Net Profit by total shares outstanding. By reducing the number of shares outstanding by buying back the shares, it increases EPS. It results in improving the company’s valuation, boosting the share price.
The rise in buybacks in recent years reflects a shift in how companies allocate capital. Instead of going after M&A, many are opting for financial engineering to boost shareholders’ value amid an uncertain and low-growth environment.
Stock Buybacks Impact on Share Price
Market Demand and Share Supply Mechanics
At its core, a buyback is a demand-side event. When a company starts buying back its shares from the market, it reduces the free float or the number of publicly traded shares. This basic market principle of supply and demand can drive up stock prices.
In 2023, Meta announced an additional $40 billion share buyback program alongside strong quarterly earnings. The announcement added to buying pressure in the stock, leading to a nearly 20% surge in a single week.
Increases EPS and Valuation Multiples
Share buybacks and EPS have a unique relationship. As we discussed earlier, reducing outstanding shares increases the EPS of the company. This leads to better valuation, like P/E. Here’s how:
- Net Income: $10 billion
- Shares Outstanding: 1 billion
- EPS: $10
If the stock is trading at $100, then P/E would be 10.
Now, the company buys back 10%, i.e., 100 million shares of its outstanding shares, the new EPS will be $11.11. An increase of 11.1%.
The P/E would reduce to 9, making it more attractive for investors.
Therefore, even without real earnings growth, this EPS can boost and translate into higher valuations.
Share Buybacks and Long-term Investor Returns
Capital Efficiency and Ownership Concentration
When outstanding shares are retired through buybacks, it results in ownership concentration. Each remaining shareholders now own a relatively large part of the company. Over time, this concentrated ownership leads to stronger capital appreciation if the company’s fundamentals and growth remain strong.
Take Apple Inc. for example. In 2013, Apple started a share buyback program. Since then, the company has repurchased $674 billion worth of shares in several tranches through the first half of 2024. This resulted in a reduction of share count by 41%. Additionally, the board of the company has authorized $110 billion for future buybacks.
This played a huge role in Apple’s stock price appreciation during this period. Since 2013, Apple stock price has increased more than 10 times, generating significant wealth for investors.
Stock Buybacks vs Dividends
Share buybacks are more tax-friendly than dividends. While dividends are taxed in the year’s income to investors, capital gains from share buybacks are taxed only when shares are tendered on buybacks. This deferral gives investors greater control over their tax obligations and can result in a higher after-tax return.
Compounding Effect for Long-term Holders
When buybacks are made at undervalued levels, and shares are held for a long time, the share repurchase effects are similar to compounding. The company uses its own cash to buy undervalued stock, improving future per-share returns for investors who hold on through multiple market cycles.
Risks and Downsides of Share Buybacks
We have seen in the cases of Meta and Apple Inc. how share buybacks have boosted their stock prices.
But, in a few cases, like those of IBM and General Electric, the opposite happened.
IBM spent over $125 billion on share buybacks between 2005 and 2015, using debt at times when revenue and margin were contracting. The goal was to consistently meet the EPS targets and keep the stock attractive among investors, despite slowing business momentum. Its revenue fell from $106 billion in 2011 to $81 billion in 2017.
Because of declining business, IBM share price underperformed the broader market, delivering negative returns from 2013 to 2020.
Similarly, in the case of General Electric, it repurchased shares worth over $40 billion between 2015 and 2017. It even launched another share buyback program worth $50 billion, aiming to boost EPS and signal confidence in the market. However, GE planned to fund the buyback program by selling valuable assets and debt.
So, when earnings began to falter in 2017 and restructuring efforts exposed deep financial strains, the stock price tumbled. By 2018, General Electric stock price had fallen by over 75% from its 2016 high. Moody’s and S&P downgraded their credit ratings.
In both cases, we have seen, buybacks without a stable core business or sustainable cash flows can impact stock prices. And, it can do more harm than good.
Therefore, if a company announces a share buyback, you should look for these potential red flags:
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- Overpaying for Shares: Whether the company is buying back shares trading at inflated valuations or not?
- Debt-Fueled Buybacks: Whether the company is using its cash reserve to fund the buyback, or going for debt-funded buybacks.
- Artificially Boosting EPS: The company is facing stagnant or declining earnings, and using a buyback to increase the EPS.
- Incentive Misalignment: Whether the executive compensation plans are linked to EPS or share price. Buybacks can be misused to inflate these metrics.
Conclusion
Stock buybacks are more than just financial optics. They can seriously impact how a company is viewed as an investment by investors. When buybacks are aligned with shareholder interests, they can improve capital efficiency, support share prices, and provide long-term investor returns.
But when it is not in line with the interests of investors, it can be harmful for the company as well as investors. Ultimately, you should look for why the company is pursuing a share repurchase rather than allocating the funds for expansion.
