Stock Buybacks: Who Benefits The Most?

When a company buys back its own stock, there are many advantages to the investor. However, there is a major advantage of stock buybacks to the company managers that we don’t normally hear about.

First, let’s talk about why we like stock buybacks.

Advantages to the Investor

  1. Buying back stock means that the company earnings are now split among fewer shares, meaning higher earnings per share (EPS). Theoretically, higher earnings per share should command a higher stock price which is great!
  2. Buying back stock uses up excess cash. The returns on excess cash in money market accounts can drag down overall company performance. Cash rich companies are also very attractive takeover targets. Buying back stock allows the company to earn a better return on excess cash and keep itself from becoming a takeover target.
  3. Buying back stock allows a company to pass on extra cash to shareholders without raising the dividend. If the cash is temporary in nature it may prove more beneficial to pass on value to shareholders through buybacks rather than raising the dividend.
  4. Buying back stock can increase the return on equity (ROE). This effect is greater the more undervalued the shares are when they are repurchased. If shares are undervalued, this may be the most profitable course of action for the company.
  5. When a company purchases its own stock it is essentially telling the market that they think that the company’s stock is undervalued. This can have a psychological effect on the market.
  6. Stock buybacks also raise the demand for the stock on the open market. This point is rather self explanatory as the company is competing against other investors to purchase shares of its own stock.

What Management Doesn’t Want You To Know!

There are several reasons why management would prefer to buy back stock rather than raise the dividend.

The first reason is that upper management typically will receive compensation that is tied to the company stock price. What this means is that they typically make more money when the stock price goes up. This compensation may come in the form of stock options, rights or other forms.

In the short term management believes that dividends may work against the stock price of a company by reducing the book value of the stock. In addition, if managers have stock options, they do not immediately benefit from dividends as their options do not qualify for dividend payments.

On the other hand, when a stock buyback occurs the short term implications on the stock price are typically positive (due to the previous listed reasons). And, since this allows management to see the most immediate results to their compensation, it is no wonder that managers prefer stock buybacks as opposed to dividend increases.

What to Watch For

As an average investor, it is beneficial to us to look for companies that have both the cash-flow to buy back shares as well as regularly increase their dividends. One specific thing to look for is the dividend payout ratio.  Companies that have a lower dividend payout ratio, say below 60% of earnings, will have more money to invest back into the company and grow the stock price.  These can be some of the best long term investments because the company finds multiple ways to increase shareholder value.

20 comments

  1. I just would like to know why Apple stopped giving dividends. I am a loyal customer of its products and planning on to invest in this company. I really appreciate if if you could give me the reasons why.

    Thanks.

  2. As usual, a great article Tyler. Management doesn’t like paying dividends, because a dividend cut gives them bad publicity in the case that the business is performing poorly.
    As for AAPL, it does seem that they were paying dividends untill 1995.. And after they suspended the dividend the stock was not the best place to be up untill early 1999..

  3. Exxon-Mobile used 32 BILLION of the 40 BILLION they made in profits in 2007 to buyback their stock. Republicans blater on about how oil companies need their profits to explore, drill and refine. That is pure bull. Oil companies don’t give a damn about exploration or they would have drilled on the hundreds of thousands of acres they have in America or offshore. Oil companies don’t even have drilling equipment to drill on land or offshore because they haven’t spent a dime on drilling equipment. Republicans actually believe oil companies are engaged in developing alternate forms of energy. That is a damned lie! They spend 100 million out of their hundreds of billions in profit on alternate forms of energy. They spend five times that amount advertising that they are developing alternate forms of energy.

    Oil companies don’t give a damn about our country’s future. All they care about is money and stealing as much as they can from the American people and people around the world. I wish people would wake up and start to vote out every republican from every office in this once great country. They are unfit to govern and they have proven themselves to be nothing more than whores and prostitutes to corporations and oil companies. Republicans say “To hell with human beings” as long as they can remain as prostitutes to their corporate pimps.

    The government needs to seize every dime of the profits from corrupt oil companies and use that money to develop alternate forms of energy. If Bush hadn’t lied our country to war every American family would have $36,000 dollars they could have used to put a solar panel on their homes making each family energy independent from corrupt energy companies. Or they could have used part of that money to buy a high MPG car. But republicans don’t think creatively. They just like to go to war to kill and destroy. They don’t like using our country’s resources to help Americans.

    Wake up Americans and stop being duped by republican propaganda.

  4. Ever thought of leaving this once great country? Canada and Mexico are taking applications.

    A country with all democrats how will that benefit us? Maybe more group hugs….. oh and they would be free….

  5. Be very careful of a stock massively buying back stock with a high short ratio. Many times executives are trying to unload their stock with insider deals. Circuit City bought back tons (over 10% annually) of stock prior to its bankruptcy. Movie Galley bought back stock, virtually all stocks ready to go bust seem to do massive buybacks.

  6. Don’t forget that dividends are a taxable event for many investors. By buying back shares, the increase in share price becomes a capital gain (taxable at a lower rate if shares are held long enough) and the investor doesn’t have to pay it until they sell the shares.

    Compared to a dividend, this is an advantage to the investor, because the dividend is always taxed as ordinary income in the year it was distributed.

  7. Bill Berggren, what you’re saying, with all due respect, doesn’t make sense. If a compnay has cash flow to buy back 10% per year, it should never had gone out of business, unless it borrowed heavily to do the buy-backs.

    It is my belief that, regardless of market sentiment, a TRULY well managed business should NEVER issue debt/borrow from the bank and issue dividends or buy-backs at the same time. You either need the money to expand, or you pay it out. You don’t borrow, at interest, to pay shareholders. That is just exec’s trying to bid up the share price to profit on their stock options.

  8. Why don’t you mention that a company must be profitable before it can “buy-back” it’s common stock?

  9. I agree, but its not just oil, America is for sale; it has been since I was a kid. Unfortunately the buyers are all outsiders, with outside interest. America is being raped, and placed back on the market by her own.
    I tell you a truth in just a few short years China will own us and the Mexicans will run this country.
    America as we know it, is gone, she died in the 70’s when we beginning to export our steal mills & factories over seas. Then in the 90’s they called it outsourcing our technology. You ever get placed on hold, when making a call to a bank or cell phone company; may goodness what country are our calls being routed too?

  10. Article hits the nail on the head by pointing out that stock buy-backs primarily benefit MANAGEMENT, not the sharaholders. I’m surprised it has never occured to any of the “brains” running our govt (both parties) that this is a bread * butter economic issue – stock buy backs are like burning money; wouldn’t that money be better spent either investing in jobs/ RD, paying down debt, or paying dividends that will recirculate real CASH (not paper profits) through the econom- as opposed to pumping up our rapidly devolving “casino” economy. Previous comment sites Exxon; Cummins Engine is another good example. A modest proposal to “restart” our economy: make it a cause of action by shareholders that, where any Board of Directors approves any compensation package to its executives based on stock price AT THE SAME TIME A STOCK BUYBACK PLAN IS IN EFFECT, both the approving board members and the receiving executives are personally liable to return to the shareholders all corporate funds expended both on the stock buyback AND any stock price based compensation. It seems obvious that there should be no CEO entitlement to stock price based compensation where the corp is artificially goosing up its stock price using profits that belong to the shareholders. Such a law would stop this eggregious practice in its tracks.

  11. in reply to av, maybe the american people need to seize every dime back from government we pay in taxes. Stop blaming everything on republicans, do really think democrats wear halos? I could name many of dems who commit tax fraud, lies, keeping money locked in a freezer,etc. Maybe wish should vote every dem out of office since their the ones who want to keep us in chains.

  12. Exxon is notorious for buying back shares and parking them in their corporate treasury rather than retiring them. This is an important distinction that this author never mentions. To have a net positive effect in terms of increasing EPS, the company must “retire” the shares they repurchase, thus removing those shares from the total shares issued. That’s the only way a buyback results in “returning money to shareholders”. Exxon on the other hand, has a record of buying their own shares as an investment when shares are cheap, and parking those shares on their books. Why? They later use these shares as currency to acquire assets when their stock is higher, a commonality in such a cyclical sector. Tech companies on the other hand are heavily engaged in issuing stock options to employees, a practice that was born out of the tech sector as a means of maintaining their talent base. When these employees exercise their options, the net effect is to increase the total shares on the market. If the corporate treasuries of these companies doesn’t step in and “mop up” these newly issued shares resulting from option exercises, they face massive share dillution and a lower EPS report. When tech companies engage in “mop up” operations, they do so with the intention of retiring their shares to keep the total number of outstanding shares, issued or not-issued, linear. Exxon does it as a prudent investor would, buying their own stock when it’s cheap, keeping it on the books as an asset, then using it when prices appreciate as acquisition currency. This is a major benefit to shareholders in terms of cash utilization and return on equity. A very important distinction that seems to have been entirely overlooked in this otherwise informative article.

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