Stock buybacks are a very popular method among corporations. If executed properly, they can benefit shareholder equity, but if mismanaged, they can also lead to company difficulties. Warren Buffett, in his 2011 letter to shareholders, mentioned that Berkshire Hathaway would only repurchase shares under two conditions:
1. Charlie and I believe that the company's stock price is far below our conservative estimate of its intrinsic value.
2. The company still has ample cash on hand after the stock repurchase.
1. What is a Stock Buyback?
A stock buyback or repurchase refers to a publicly traded company buying back its own common stock that was issued to the public.
The repurchased stocks can be directly canceled to reduce the company's registered capital, or kept as "treasury stocks." Although treasury stocks are still considered issued, they do not participate in dividends or earnings per share distribution. "treasury stocks." can later be used for convertible bond issuance, employee benefit plans, or resold in the market when funds are needed.
2. What are the Reasons for Stock Buybacks?
There are generally four reasons why a company might buy back its shares:
2.1 Motive for Stock Buyback 1: Boost Stock Prices
When a company buys back its own stock, it sends a message to the market that the management team is optimistic about the company's future or believes that the stock is undervalued. This can boost investor confidence and subsequently reflect in the stock price.
In the event of a stock market crash, many companies also use stock buybacks to prevent a drastic drop in stock prices. For example, during the 1987 New York stock market crash, about 650 companies conducted massive stock buybacks within two weeks to stimulate a rebound in stock prices.
Note:
The timing and price of the buyback are crucial as it uses the company's funds. Companies that buy back stocks at market highs may be trying to benefit large shareholders and support the stock price for them to offload their shares. A buyback is truly beneficial to all general shareholders only if the purchase is made at a low price.
2.2 Motive for Stock Buyback 2: Maximize EPS and Enhance Intrinsic Value
Earnings Per Share (EPS) is one of the key indicators in the investment market, offering a quick understanding of a company's profitability.
Its formula is: EPS = Earnings / Share.
Therefore, under the premise of constant net profit after tax, the fewer the number of common shares in circulation, the higher the EPS. Stock buybacks reduce the number of shares in circulation, thereby maximizing EPS. When investors anticipate an increase in EPS, the stock price also tends to rise, enhancing the company's intrinsic value.
Note:
Many companies that have lost their organic growth momentum can still increase their earnings year after year, thanks to the stock buyback mechanism. Of course, this has its pros and cons, and the risks will also be mentioned later.
2.3 Motive for Stock Buyback 3: Cash Flow Management
Buffett once said, "Buy back your stock when the price is reasonable, and there is no simpler way to make money for your shareholders." Indeed, when a company holds a large amount of cash but lacks better investment opportunities, using cash to buy back its own stock is a safer option, which can improve the efficiency of capital utilization.
For example, Berkshire Hathaway's cash level continuously hit new highs in 2020, exceeding $130 billion in April, and later announced a $5.1 billion stock repurchase in the second quarter, the largest in its history.
Moreover, companies can use not only cash but also financial leverage to buy back stocks.
For instance, when a company has low debt and low market financing costs, and the expected benefits of the buyback are good, the company can increase its debt for stock repurchases. The interest on debt can lead to tax savings and increase expected returns.
Note:
When a company has a lot of cash, it can also choose to pay cash dividends, but this is generally less tax-efficient for shareholders. Therefore, buybacks are another alternative.
2.4 Motive for Stock Buyback 4: Prevent Takeovers by Other Companies
In the United States, hostile takeovers among enterprises are very common. Companies can acquire a large number of shares in the target company on the market to gradually take over. Therefore, many companies buy back their own stocks in large quantities to maintain control.
A typical case is Phillips Petroleum in 1985, which used $8.1 billion to buy back its own shares to prevent a hostile takeover.
Note:
Generally, when a company must resort to stock buybacks to prevent takeovers, the buyback can excessively elevate the stock price and deplete cash, which is a Pyrrhic strategy. Regardless of success or failure, this is disadvantageous for the company in the long term, as it incurs unnecessary costs. However, original shareholders can choose to sell when the price is high.
3. What are the Pros and Cons for the Original Shareholders?
3.1 Pros of Stock Buybacks
3.1.1 Wealth Increase: Stock price increases caused by stock buybacks can increase the assets of the original shareholders.
3.1.2 Tax Savings: If a company opts for stock buybacks, then the original shareholders do not need to pay taxes until they sell their stocks. Even if they sell their stocks after a price increase, if the capital gains tax is lower than the dividend tax, there is still a tax-saving effect for the original shareholders.
3.1.3 Avoiding Significant Stock Price Fluctuations: If a company uses stock buybacks to suppress a significant drop in stock prices and then sells at opportune times in a good market, it can increase the stability of the stock price, providing more security for the original shareholders.
3.2 Cons of Stock Buybacks
3.2.1 Risk of Inhibiting Investment: If a company with insufficient cash conducts stock buybacks, it will lack sufficient funds for future investments, potentially causing a cash shortage and hindering the company's long-term development.
3.2.2 Risk of Being Trapped: If the company buys back its shares at a high price but the stock price does not rise thereafter, there may be a risk of being trapped, leading to the company being unable to realize profits for a long time.
3.2.3 Cash Shortage: This is the biggest problem. Although the company uses surplus cash for the buyback, in times of market downturn, a cash-strapped company may face a cash crisis.