Stock Buybacks: A Good Signal or a Waste of Money?
In his 2023 State of the Union address, President Joe Biden said he wants to “quadruple the tax on corporate stock buybacks to encourage long-term investments instead.”
Biden was referring to the fact that publicly traded companies collectively spend hundreds of billions of dollars each year buying their shares back from the stock market to increase their prices. But is that a good thing?
Conventional wisdom says that, yes, stock buybacks are good for investors because they make prices go up. But economists are divided about whether stock buybacks are a positive signal from companies, nor are they sure how new taxes and rising interest rates might affect future stock buybacks.
What is a stock buyback?
“A stock buyback is exactly how it sounds. It’s when a company purchases its own stock off of the open market from other investors,” said Scott McConnell, a professor of economics at Eastern Oregon University, in an email interview.
Stock buybacks are sometimes called share buybacks, share repurchases or share purchase authorizations.
Most stock buybacks are open market buybacks, in which a company buys its shares from an exchange just like any other investor. However, companies can also perform stock buybacks at a fixed price, by auction, option contracts or negotiating directly with a few large shareholders.
Are stock buybacks good for investors?
In the short term, stock buybacks can have a stimulating effect on a company’s shares. For example, on Feb. 1, Meta — formerly known as Facebook — announced a $40 billion stock buyback. Meta shares jumped on the announcement and afterward had gained roughly 25% by the end of that week.
Jennifer Koski, a professor of finance at the University of Washington, says that stock buybacks are a positive signal for investors.
“The fact that I’m considering going out and buying my own stock typically means I, as the management, think my stock is undervalued,” she says.
But McConnell says this isn’t always the case. “A stock buyback is not necessarily a positive signal, as the company is not utilizing its resources for investment and expansion of the firm, but rather just purchasing its own stock back,” he said.
Are they good for companies?
Stock buybacks can certainly increase share prices — but are they a good use of company money? That’s a more complicated question.
McConnell and Koski say that a stock buyback can use money that would otherwise be reinvested to improve the business.
McConnell also pointed out that a stock buyback can be self-serving for the people who run the company. “It’s a way to reward the largest shareholders in the business — often managers and executives themselves,” he said.
“It is not actually increasing the efficiency or productivity of the firm in any way, but rather just concentrating ownership to fewer, larger investors,” McConnell said.
Koski, however, notes that some companies buy back shares because they can’t think of any good way to spend the money internally.
“Perhaps they’re just generating so much cash that they don’t need to use all of their surplus cash flow to invest in their business — which incidentally has recently been true for a lot of the big tech companies,” she says.
What’s the deal with the stock buyback tax?
The Inflation Reduction Act of 2022 introduced a 1% excise tax on stock buybacks, which came into effect at the beginning of 2023.
In his State of the Union address, Biden said he wants to bump that tax to 4%. A few days later, Democratic Sens. Ron Wyden of Oregon and Sherrod Brown of Ohio introduced the Stock Buyback Accountability Act of 2023, which would do that. However, it’s unclear whether such a bill could pass the Republican-controlled House of Representatives.
The stock buyback tax is new, and neither Koski nor McConnell is sure what effect it will have.
“Other things being equal, if they start taxing repurchases, I would expect to see fewer repurchases,” Koski says.
Two think tanks — the Institute for Taxation and Economic Policy and the Tax Foundation — have released white papers predicting that the new tax might incentivize companies to pay dividends instead of buying back shares. Both think tanks also say the tax could raise billions of dollars in the next few years.
How do rising interest rates affect stock buybacks?
Koski says that the recent increase in interest rates could have a cooling effect on stock buybacks. “Some companies deliberately issue debt and use the money to buy back stock,” she says.
“They’re less likely to do that right now when interest rates are higher,” Koski says.
McConnell added that companies might opt to buy bonds instead of their own shares as bond interest rates increase.
A 2019 report from the Congressional Research Service suggested the surge in stock buybacks during the 2010s was partially a result of low interest rates during that decade, implying that stock buybacks may be less appealing to companies during higher-rate periods.
Will stock buybacks become a thing of the past?
There are a lot of unanswered questions about stock buybacks. Experts disagree about whether they’re an efficient use of company money and whether they’re really a positive signal for investors.
McConnell and Koski both say that the new tax could have a negative effect on future stock buybacks, although they’re uncertain how much it will move the needle. They also generally agree that rising interest rates could make stock buybacks less appealing for companies.
With this in mind, it’s too early to say whether companies will keep spending hundreds of billions of dollars each year on stock buybacks going forward as they have for the last few decades.
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