A Balanced Look at Stock Buybacks Part 1: How Do Stock Buybacks Work?
Stock buybacks—i.e., a company repurchasing shares of its own stock—have been targets for praise and criticism through the years. So, which are they: good or evil? We agree with The Wall Street Journal columnist Jason Zweig, who once wrote-
“Buybacks are neither bad nor good. They are simply a tool. Just as you can use a hammer either to build a house or knock one down, buybacks are useful in the right corporate hands and dangerous in the wrong ones.”
In other words, a stock buyback can help you, hurt you, or be a neutral event, depending on the particulars. Today, let’s embark on a balanced look at stock buybacks.
Big Picture: Diversification Is Still Our Best Friend
Before we dive into any details, let’s answer a bigger question: No matter how you may feel about stock buybacks, what should you do about them as an investor? If you’re familiar with our general investment strategy, our answer will come as no surprise:
Stock buybacks give investors yet another reason to prefer widely diversifying their investing across myriad asset classes around the world, rather than trying to get ahead by deliberately picking or avoiding particular stocks or industries.
As with any stock bid, even a well-devised buyback can backfire if the future doesn’t unfold as hoped for. It can be even worse if the buyback motives were shaky to begin with. Because we can’t predict, we advise investing across a globally diversified portfolio of low-cost mutual funds or ETFs, using fund managers who avoid engaging in market-timing or stock-picking. That way, you’ll continue to capture long-term market growth—including any returns generated by stock buybacks—without needing to assess each one as it occurs.
In this context, let’s look at how buybacks generally work. Even if you’re not actively participating in individual stock buybacks, it’s worth being informed about them—especially if you’re employed at a company that may periodically offer them.
How Do Stock Buybacks Work?
In general, you and other traders can buy or sell any publicly traded stock on an open exchange like the NASDAQ or New York Stock Exchange (NYSE). Similarly, a company can participate in these same exchanges, using its retained earnings to buy back or extend a tender offer to repurchase some of its own stock.
However, just because a company wants to buy back shares, does not mean you have to sell any of yours. A stock buyback offer is just like any other trade on the open market. Before a trade occurs, would-be buyers and sellers must agree on a fair price.
There is also one noteworthy difference between a stock buyback versus simply selling stock to another trader. In a “regular” trade, one of you is the seller, and the other is the buyer. End of story. But when you own a company’s stock, you own a piece of its capital, making you a co-owner. Thus, in a stock buyback, you may have vested interests on both sides of the trade.
And that’s where things get interesting. How do companies use (and occasionally abuse) stock buybacks to deliver sustainable value to its shareholders? We’ll explore that in our next piece!