When it comes to investing in the stock market, stock BuyBacks are very controversial and quite an interesting subject. Depending on who you ask, people can see them as an excellent way to earn tax advantage returns to shareholders. Others, on the other hand, see them as a complete waste of money. So what exactly are stock BuyBacks?
In this article, we will go over what exactly stock BuyBacks are, and see how they affect you. Spoiler alert, they do affect you in one way or another.
What Are Stock Buybacks?
A stock buyback is when a company buys its own outstanding stocks to reduce the number of remaining shares on the market. This basically means that a company can reduce the size of the pie by repurchasing some of its own stocks.
I know what you’re thinking, “Wait a minute. This sounds like market manipulation! Is this legal?” To answer your question, yes it is very legal, but that wasn’t always the case.
Stock BuyBacks what’s considered illegal for decades until the law was changed. In 1982, Ronald Reagan appointed and new head of the SEC that’s changed everything. The SEC adopted a new rule named 10b-18 which would provide a safe harbor for companies to perform stock BuyBacks.
It was said that as long as companies do not purchase more than 25% of the Stock’s average daily trading volume in a single day, stock BuyBacks would be legal.
I like to see this as Legal Market Manipulation, or LMM for short. (I made that up)
Advantages of Stock Buybacks
Now that we have an idea of what stock BuyBacks are, we can look at the advantages that come with this practice. Like any coin, they are two sides to the story. Let’s start off with the advantages.
Firstly, a company usually repurchases its own stock on the public stock market. This means that the company will be buying the stocks from any investor who wants to sell the stock. It runs on the same principles as any other stock market transaction. When a company is performing a stock buyback, this is advantageous to the stockholders that want to sell stocks of that company. It makes finding a buyer easier.
By reducing the number of shares left in the market, stock BuyBacks increase the value of each share remaining. It’s simple economics. Because there are fewer actual stocks left in the market, the value of the remaining stocks has the potential to increase.
Stock BuyBacks also demonstrate that the company’s management has some confidence in their company. Companies that are struggling typically do not perform BuyBacks. This is because the company does not want to be holding worthless stocks in case they foresee something bad happening in the future.
Disadvantages of Stock Buybacks
As much as stock BuyBacks can create value in the market, it can just as easily destroy it. Here are some disadvantages that come with stock BuyBacks.
Firstly, when a company performs a stock buyback, there is a possibility that they could have used the money for something more productive. Instead of working on manipulating the market, The company could have instead use the money for research and development. They might also have used the money to better employees’ compensation or working conditions. These are just a few examples, but the fact remains. There can be always better uses of money than buying back your own stocks.
Secondly, stock BuyBacks may be for the sole purpose of enriching management and owners. Since management and the business owners typically have a stake in the company’s stock market performance, they may have an incentive to influence the stock prices. As I mentioned at the advantages above, performing stock BuyBacks typically has a side effect of increasing the value of remaining stocks. This may be something to note.
Lastly, there are times where stock BuyBacks were not executed well or badly timed. Since the company is using its own funds to you purchase back their own stocks, it’s done right before an economic downturn, for example, it might put the company in a serious predicament.
How does this affect you?
If you own stocks of a company performing stop buybacks, then both the advantages and disadvantages above will affect you. Stock BuyBacks may increase the value per share of what you hold, or it can easily go the opposite direction. You might end up losing a lot of value in your stocks depending on how the stock buyback goes.
Typically, individuals don’t really own enough stock in a single company to affect them in a big way. However, this doesn’t mean that you are completely excluded. Your own stock portfolio or even your retirement fund may be skewed by a particular company. Their actions, especially when it comes to stock BuyBacks, may have a significant impact on your funds and portfolio.
On the other hand, if companies didn’t do so many stock BuyBacks, but instead work on increasing employees’ wages, then that might end up benefiting the economy as a whole. This will directly or indirectly affect you too!
People usually think that decisions made by corporations have zero effect on their lives. On the contrary, it might actually have a ripple effect not only on your personal portfolio but on job opportunities and the economy as a whole. Not trying to sound political or anything, it’s definitely something to keep in mind and to consider.
If you haven’t started investing and are interested in doing so, then I most definitely recommend getting started with Acorns. Doesn’t take any experience to start investing, and it’s never too late to start either.
Let me know if you are actively investing and if you’ve ever been directly or indirectly affected by stock buybacks in the comments below.