What is a stock buyback?

Stock buybacks are controversial — and for good reason. While they may serve as an opportunity for businesses to give back to shareholders, they also hold the potential for abuse from company executives.

What is a stock buyback?

A stock buyback, also known as a share repurchase, occurs when a company purchases its own shares from the open market or directly from shareholders. These shares are typically cancelled or held as treasury stock, reducing the total number of outstanding shares.

Buybacks are a way for companies to return capital to shareholders, similar to dividends. By lowering the share count, they can increase metrics such as earnings per share (EPS), although this doesn’t automatically translate into a higher share price. Price movements depend on investor perception and the company’s underlying financial performance.

How do companies conduct stock buybacks?

Before executing a buyback, companies typically prepare a repurchase authorization, which is a board-approved plan that sets the maximum number of shares or total dollar amount the company is permitted to repurchase over a specified period.

There are three ways for businesses to execute stock buybacks:

• Tender offer. Companies approach shareholders and make a tender offer to buy back individual shares, sometimes offering a premium to help incentivize the offer. Investors aren’t obligated to accept, but can opt to sell back their shares if the offer aligns with their investment goals and time horizons.
• Dutch auction tender offer. This is a type of tender offer where companies set a price range for the buyback and invite shareholders to indicate how many shares they’re willing to sell at specific prices within that range. The company then determines the lowest price at which it can repurchase the desired number of shares, and all accepted shares are typically bought back at that final price.
• Open market. Companies purchase available shares from the open market at the current market price of the stock. These purchases are typically spread out and executed through brokers within regulatory limits.

Advantages of buybacks

Stock buybacks can offer several benefits to shareholders and the company, such as:

• Increasing ownership stakes for existing shareholders. When a company reduces its number of outstanding shares, each remaining share represents a larger percentage of ownership in the business. For example, if a company has 100 shares outstanding and you own 1 share, you own 1% of the company. If it reduces shares outstanding to 80, your 1 share now represents a 1.25% stake.
• Enhancing earnings per share. Fewer shares outstanding mean earnings are spread across a smaller base, which can improve per-share metrics and potentially make the stock more attractive to investors.
• Supporting the share price. By reducing the supply of shares in the market, buybacks can create upward pressure on the stock price, particularly if demand remains steady.
• Signaling management confidence. Share repurchases may indicate that management believes the stock is undervalued or that the company has strong future cash flow prospects.
• Offering tax flexibility for shareholders. Compared to dividends, buybacks allow shareholders to choose whether and when to realize capital gains, which can be more tax-efficient in some cases.

Disadvantages of buybacks

While stock buybacks can be an effective way to return capital to shareholders, they also carry several potential risks and drawbacks that investors should be aware of, including:

• Boosting EPS without improving earnings. Reducing share count can make per-share metrics look stronger even if underlying profits are unchanged.
• They involve an opportunity cost of capital. If companies use cash for buybacks, they can’t allocate it towards other growth opportunities like research and development, acquisitions, debt reduction or other long-term investments.
• Increasing financial risk. If a company finances buybacks with debt, it can weaken its balance sheet and increase interest obligations. If share prices fail to recover, the company may also damage its credit profile and put its cash reserves at risk.
• Encouraging short-term decision-making. Buybacks can be used to help meet earnings targets tied to share price performance. This can create incentives to prioritize financial engineering over longer-term investments in the business.
• Reducing financial flexibility. Lower cash reserves can limit a company’s ability to respond to downturns or unexpected costs.
• Distorting market signals. Investors may interpret buybacks as stronger confidence in future performance than is actually warranted.
• They can be poorly timed. Companies may repurchase shares when valuations are high, reducing the efficiency of capital allocation.

Why do companies buy back stock?

There are a number of reasons companies buy back stock — some designed to benefit the shareholder and others with the intent of bolstering the company.

Consolidate ownership

Every outstanding share represents a slice of ownership in a company, and this ownership can be accompanied by the right to vote on company policies and financial decisions. With fewer shares on the market, a company can increase the ownership percentage and voting power of remaining shareholders. In some cases, buybacks can also help founders and company insiders maintain or strengthen their voting influence if they retain their shares while the total number of outstanding shares declines.

Return excess capital to shareholders

Companies issue shares to raise money, often to fund growth and expansion. However, mature companies may eventually generate more cash than they can profitably reinvest in the business. Rather than letting excess cash sit idle, companies can return capital to shareholders through dividends or buybacks. By repurchasing shares, a company reduces its number of outstanding shares and distributes excess cash to shareholders who choose to sel their stock.

Signal confidence in an undervalued stock

If a company’s leadership believes its shares are trading below their intrinsic value, it may choose to repurchase stock. Buybacks can signal management’s confidence in the company’s future prospects and may increase the value of remaining shares by reducing the number of shares outstanding.

Companies may also use buybacks during periods of market weakness when they believe their stock price doesn’t accurately reflect the underlying strength of the business. However, there’s no guarantee that the share price will recover or that the buyback will create value for shareholders.

Reduce dilution

A company may also engage in a stock buyback to offset the dilution that may occur when employees exercise their stock options. When they do that, the number of the company’s outstanding shares goes up. This means existing stockholders now own a smaller percentage of the company, and earnings are spread across a larger number of shares.

This can reduce earnings per share and other per-share metrics that investors use to assess company performance. To offset these effects, companies may repurchase shares, reducing the number of outstanding shares and helping maintain existing shareholders’ ownership stakes.

Improve financial ratios

Stock buybacks can affect key financial ratios such as earnings per share, return on equity and, indirectly, valuation multiples like the price-to-earnings ratio. By reducing the number of outstanding shares, a company spreads its earnings across fewer shares, which typically increases EPS.

However, higher per-share metrics resulting from buybacks don’t necessarily indicate an improvement in the company’s underlying business performance, as the company is using cash to repurchase shares rather than generating additional earnings.

Protect from hostile takeover

Stock buybacks may help a company protect itself from hostile takeovers — a process through which an acquiring company attempts to take over a target company against its wishes. By reducing the number of shares available on the market, a buyback may increase the share price and make an acquisition more expensive for a potential buyer.

In some cases, companies also use cash reserves or take on debt to fund a buyback, which can make the company less attractive to a buyer. However, buybacks are just one of several takeover defense strategies and don’t guarantee protection from an unwanted acquisition.

More flexible capital returns

Unlike dividends, which investors often expect companies to maintain or increase over time, stock buybacks can be conducted on an as-needed basis. This gives companies more flexibility to return capital to shareholders without creating expectations of ongoing payments.

What do companies do with buybacks?

Once a business has repurchased its shares, it can do one of two things: it can keep the shares as treasury shares or it can cancel them outright.

• Treasury shares: These are shares that have been bought back but not cancelled. They don’t receive dividends, carry voting rights or count as outstanding shares for earnings-per-share calculations. Companies may reissue these shares, typically for employee compensation plans or acquisitions.
• Retired (cancelled) shares: These shares are permanently removed from circulation and cannot be reissued. This reduces the total number of shares outstanding.

What a business chooses to do with its shares after a buyback depends on why they were repurchased in the first place. If it’s attempting to rehabilitate the value of its stock, it may want to keep its shares as treasury shares so that they can eventually be reissued. But if it’s attempting to consolidate ownership or reduce the cost of equity, it may prefer to cancel the shares outright.

Stock buyback alternatives

For a company looking to give back to shareholders, improve its stock or invest in itself, there are a few alternatives to buybacks:

• Cash dividend. A company can distribute profits directly to shareholders in the form of regular or special cash payments.
• Acquisitions and expansion. Businesses can use excess cash to acquire other companies, enter new markets or expand operations.
• Reinvest in the business. Companies may invest in research and development, new products, infrastructure or other growth initiatives.
• Debt reduction. Paying down existing debt can strengthen the balance sheet and reduce interest costs.

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How investors should evaluate stock buybacks

As an investor, here are some key factors you can look at to assess how and why repurchases are being carried out:

• Whether the company has a strong free cash flow to support buybacks without weakening its balance sheet.
• Whether total shares outstanding are actually declining over time, or simply being offset by employee stock-based compensation.
• Whether buybacks are being made at reasonable valuations rather than during periods of market overvaluation.
• Whether the program is financed through debt, which can increase financial risk during downturns.
• Whether executive compensation structures may incentivize short-term EPS boosts rather than long-term value creation.

Bottom line

Stock buybacks can be used for a variety of purposes. Some buybacks are executed with the intention of benefiting shareholders; others have been criticized as a method of stock manipulation. Ultimately, buybacks are a capital allocation tool rather than inherently good or bad. Their impact depends heavily on timing, valuation, financing method and whether they genuinely reduce share count or simply offset dilution.

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Frequently asked questions

• How are stock buyback gains taxed?

  For shareholders, tax treatment depends on whether they sell their shares. If shareholders sell into a buyback (such as a tender offer), any profit is generally taxed as a capital gain. If they don't sell, no tax is triggered, even if the share price changes after the buyback.

  For companies, stock buybacks aren't directly taxed as income, but they may be subject to a corporate-level share buyback tax in some jurisdictions. For example, Canada introduced a 2% tax on net share repurchases for certain large publicly traded companies starting in 2024. Companies may also incur transaction costs, but the buyback itself isn't treated as taxable income.

• How do stock buybacks affect the price-to-earnings (P/E) ratio?

  The price-to-earnings (P/E) ratio measures a company's share price relative to its earnings per share. Because stock buybacks reduce the number of shares outstanding, they typically increase EPS even if total company earnings stay the same.

  When EPS rises due to a lower share count, the P/E ratio can decrease if the share price doesn't change proportionally. This may make the stock appear more attractively valued, even though the company's underlying profitability hasn't increased. In short, buybacks can improve per-share metrics like EPS and influence the P/E ratio, but they don't necessarily reflect stronger overall business performance.

• What's the difference between a share buyback and a dividend?

  A dividend is a direct cash payment that a company distributes to shareholders on a per-share basis, giving investors immediate income while they retain their shares. A share buyback occurs when a company uses cash to buy its own shares from the market, reducing the number of outstanding shares and often increasing the value of remaining shares by boosting earnings per share and ownership percentage. In short, dividends return cash to shareholders, typically on a regular basis, while buybacks return value by increasing each remaining share's stake in the company.

• Are stock buybacks illegal?

  Not in Canada. Stock buybacks are legal but regulated, and Canadian companies regularly use share repurchase programs as part of capital allocation strategies.

  In the US, stock buybacks have long been permitted, although their execution is regulated under securities law. In 1982, the U.S. Securities and Exchange Commission introduced Rule 10b-18, which provides companies with a safe harbour from market manipulation liability if they follow certain conditions related to volume, timing and price when repurchasing shares.

  More recently, during the COVID-19 pandemic, US companies that received certain government loans or financial assistance were temporarily restricted from conducting share buybacks while those conditions applied.

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