Before the 1980s, corporations rarely repurchased shares of their own stock. But this year alone S&P 500 firms are buying back stock at double the pace of last year. It is forecast that there will be at least $1 trillion in completed corporate stock buybacks by the end of the year.
All this despite a 1 percent tax included in the Inflation Reduction Act that went into effect on January 1 that is designed to slow stock buybacks. Corporations that are awarded a piece of the $39 billion in grant money under the CHIPS and Science Act may also be barred from doing corporate stock buybacks.
Now the White House wants to further increase taxes on stock buybacks. In his recent State of the Union address, President Biden said the tax should be much higher. “Corporations ought to do the right thing. That’s why I propose we quadruple the tax on corporate stock buybacks and encourage long-term investments. They will still make considerable profit.”
That comment may have led the Oracle of Omaha, Warren Buffet, to weigh in on the hot button issue in the Berkshire Hathaway CEO’s annual letter to investors touting the benefits of repurchases: “When you are told that all repurchases are harmful to shareholders or to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue (characters that are not mutually exclusive).”
Still, Buffet included a caveat: he says buybacks make sense only if they are made at “value accretive prices,” i.e. when corporation don’t overpay.
Taking a step back, corporations have a number of ways to allocate capital:
- Make capital investments designed to grow their businesses. For example, buying new machinery or pouring more resources into research and product development;
- Acquire or merge with another company or business unit that the corporation believes could help grow its core business;
- Pay regular cash dividends to shareholders that tend to be more reliable than stock buybacks, an actual real return of cash to investors; and
- Use the money to repurchase their shares—a stock buyback automatically increases earning per share and has a stronger short-term impact with little, if any, tax consequences for shareholders.
As with many things in finance, the answer to whether stock buybacks are good for investors is “it depends.”
If a corporation sees its shares as undervalued and is flush with cash, a buyback could be a way to generate shareholder value. A share buyback reduces the number of the corporation’s outstanding shares in the stock market and, theoretically, its share price should rise. Shareholders will own a bigger portion of the corporation and therefore a bigger portion of its earnings.
In theory, a corporation will pursue stock buybacks because they offer the best potential return for shareholders with relatively lower risk than other options for allocating capital. When a corporation announces a stock buyback, it makes sense to ask if the firm believes its stock is cheap, or if there are other factors at play, such as senior management lining their own pockets in the case of a compensation incentive for executives based on stock price.
Also, investors are concerned if the stock buybacks are financed with debt, unlike dividends that are typically paid for out of cash flow, which makes the corporation’s balance sheet less resilient. Of course, it is a good sign if senior management is also buying company stock for themselves.
The tricky part in considering corporate stock buybacks is making sure senior executives are focused on sustainable long-term growth opportunities rather than increasing stock prices and engaging in share price manipulation while prioritizing the short-term.