By Ee Hsin Kok. Edited by Arjun Chandrasekar.
There are multiple ways for successful companies to return value to their shareholders. Probably the most well-known of which is through giving a dividend. Yet, another less commonly known way in which companies can return values to their shareholders is through stock buybacks.
How They Work
When a company initially lists on an exchange, it sets a given amount of outstanding shares to be traded in the marketplace. During a stock buyback, companies reduce the number of outstanding shares by buying them back. Since the company still makes the same amount of money but there are fewer shares to be distributed to, these buybacks increase the earnings per share (EPS) of the company.
Why They Are Used
When companies become very successful, they often come to a point where they are generating a lot more cash than they can reinvest into the business. This excess cash, therefore, needs to be returned to shareholders. Stock buybacks are one of those ways in which value is returned. It rewards shareholders by driving up the earnings per share, which increases the intrinsic value of the stock, and that then leads to increased price appreciation over time.
Stock buybacks are also a great way for a company to invest in itself. Since buybacks can be done at market price, if a company believes the market is seriously undervaluing its stock, it can buy back its own shares at that undervalued price. Oftentimes, stock buybacks are done by companies who have unused excess cash and who believe that their own stocks are undervalued.
Stock Buybacks vs. Dividends
As mentioned above, stock buybacks are a way to utilize excess cash to return value to shareholders. However, value can also be returned to shareholders via dividends. So what makes a company opt for share buybacks as opposed to dividends?
The first big reason is for tax purposes. Dividends are given out to shareholders on a fixed basis and are considered as ordinary income for shareholders, thus forcing them to pay a tax on it. However, with stock buybacks, investors receive value in the form of the increased potential for price appreciation. Since investors can choose when they want to sell their shares, they can choose to defer their tax burden to a future period when tax laws change and capital gains are lowered, or to a year where their income is down. Additionally, not all investors are subject to capital gains tax. Capital gains tax is non-existent in countries like Hong Kong and Singapore. So for foreign investors from these countries, stock buybacks which return value in the form of capital gains, are far more advantageous.
Another reason why a company may opt for stock buybacks is that it signals to shareholders that the company believes in itself. As mentioned previously in this article, stock buybacks are done by companies who believe their own shares are undervalued. So by buying their own shares back, it signals to shareholders the company’s confidence in itself.