August 25, 2022
Stock Buybacks – How do they work?
Stock buyback have been getting negative press lately. The recently signed Inflation Reduction Act calls for a 1% excise tax on these transactions. Many proponents of this tax hope it will dampen the enthusiasm for stock buybacks. It is not clear why.
Stock buybacks are a legitimate technique for value maximizing managers to distribute excess cash to shareholders. Cash is a nonproductive asset. Theoretically, if a firm has productive uses for cash, it should undertake them, if not, surplus cash should be distributed to shareholders. This excess cash could come from a reduction in taxes. If there are no good uses in the company for this cash, a stock buyback is a legitimate way to return it to shareholders.
Stock buybacks do not create value – fewer shares are offset by reduced cash. Repurchasing shares that are priced in a well-functioning market is a “zero-sum” transaction. Observed increases in stock price might reflect reduced tax rates, signaling new information, or other factors but not buybacks per se. It is not productive for management to keep unnecessary cash in the company to avoid criticism of a stock buyback.