#How Stock Buybacks Work
Stock buybacks can boost a company's share price, but how exactly do they work? And why do companies sometimes speed things up with an accelerated share repurchase?
When a company buys back its shares, it reduces the total number of shares available on the market. Fewer shares mean higher earnings per share (EPS), making the stock more attractive to investors. Strong EPS growth often leads to rising stock prices, benefiting both management and shareholders.
Companies usually announce a buyback program and execute purchases over time. This process can signal that the company believes its shares are undervalued, though motivations vary widely.
#An Example of a Traditional Buyback
Here's how it works:
Say Company X has 10 million shares and earns $10 million in profit. That means earnings of $1 per share. If the company repurchases 2 million shares, now only 8 million shares remain. Earnings per share jump to $1.25, even though overall profits have not changed. Investors view this as a positive sign, and the stock typically moves higher.
But traditional buybacks are gradual. Companies execute them based on stock price conditions, market sentiment, and available cash flow. There is no guarantee the entire program will be completed, but most large-cap companies that announce buybacks do ultimately complete them.
#What Is an Accelerated Share Repurchase?
Traditional buybacks can take months or even years to complete. And that is where accelerated share repurchases (ASRs) come in.
With an ASR, a company quickly reduces shares outstanding by paying an investment bank upfront. The bank borrows shares from institutional investors and immediately delivers them to the company. Over the following months, the bank buys back shares in the open market to cover its position. During this time, the bank, not the company, bears the market risk.
ASRs are often structured with "collars," which set price limits that adjust the number of shares the company ultimately retires, based on the stock’s average price during the buyback period.
#Why Choose an Accelerated Repurchase?
It provides immediate impact on EPS.
Companies can signal confidence to investors.
It avoids the prolonged uncertainty of open-market buybacks.
It reduces dilution faster if stock options or equity compensation are significant.
ASRs account for a small portion of all buybacks by S&P 500 companies, possibly around 10%. Companies like Apple use ASRs to manage their large cash reserves, helping bolster its stock price in the short term.
Banks like Goldman Sachs and JPMorgan often facilitate ASRs, providing flexibility to companies while locking in favorable pricing mechanisms.
#Are Accelerated Repurchases Always Good News?
Not necessarily. Some investors worry when companies aggressively repurchase shares. They ask, "Is the company out of growth ideas or investment opportunities?" Or, "Is management simply trying to boost short-term stock prices at the expense of long-term growth?"
Companies performing buybacks also take the risk of timing the market badly, repurchasing shares when prices are high rather than low. This can waste investor money and limit the company's financial flexibility. Historical data shows many companies repurchased heavily in 2007-2008 before the financial crisis, locking in high purchase prices before stocks crashed.
Investors should ask whether a buyback makes strategic sense or if it is a short-term earnings management tool.
#Financial Metrics and Regulatory Risks
Accelerated share repurchases affect more than EPS. They improve Return on Equity (ROE) because equity shrinks when shares are retired. They lower the Price-to-Earnings (P/E) ratio because earnings per share increase, making valuations look cheaper.
These changes can paint a rosier financial picture without actual business improvement.
Investors should also stay alert to regulatory changes. In the US, a 1% excise tax on share buybacks came into effect in 2023. Politicians are also discussing higher taxes or restrictions on buybacks if companies are laying off workers or cutting investment in growth.
Canada has similar discussions ongoing about tightening oversight on how companies use free cash flow.
Companies also face scrutiny from activist investors and the public, especially if buybacks are seen as benefiting management compensation tied to stock performance.
#Tax Considerations for Investors
Buybacks affect taxes differently than dividends. Dividends generate immediate taxable income, while buybacks can increase stock prices, leading to capital gains taxes only when shares are sold.
In the US, long-term capital gains are taxed at 0%, 15%, or 20% depending on income levels. High-income earners may be subject to an additional Net Investment Income Tax on capital gains and dividends.
In Canada, 50% of a capital gain is taxable at an individual's marginal rate, while dividends have their own tax credit system but can be taxed at higher rates for high earners. These amounts are periodically updated, so it is important to keep track.
For many investors, this deferral of taxes makes buybacks more attractive than cash dividends. But investors who need income may prefer dividends.
Understanding your personal tax situation is critical when evaluating whether buybacks create true value for you.
#How to Evaluate an Accelerated Share Repurchase
So, what should you do when a company announces an accelerated buyback?
Consider the company's reason for buying back shares. Is it because the stock is undervalued, or is it out of strategic ideas?
Check the company's debt levels. Using debt to finance buybacks can create risks down the road, especially if interest rates rise.
Evaluate the company's overall business health. Strong profits and stable growth are better indicators of long-term success than buybacks alone.
Review management's track record. Companies with a history of disciplined capital allocation tend to use buybacks more wisely.
Understand your tax situation. Higher share prices may mean higher capital gains taxes if you sell.
Watch for the scale of the buyback. Is it large relative to market capitalization? Bigger buybacks often move the needle more significantly.
If you see a company funding buybacks while maintaining investments in R&D, hiring, and expansion, it is usually a healthier signal than a company cutting costs everywhere else just to return cash to shareholders.
When understood clearly, accelerated share repurchases can provide useful insights into a company's strategy. They often boost share prices in the short term, but wise investors always look at the full picture.
Buybacks alone rarely make a mediocre company great. But for strong companies, they can be a useful tool to reward shareholders and support long-term value creation.