Why Buybacks Connotate a Rise in Share Prices, Tax Gains, and Shareholder Optimism

Synopsis:

Typically, companies can return wealth to shareholders through stock price appreciations, dividends, or stock buybacks. In the past, dividends were the most common form of wealth distribution. As of recent, however, there’s been a fundamental shift in the way companies deploy capital, with buybacks rising as time presses on. For professional traders, buybacks can hold many positive connotations — including a rise in share prices, tax benefits and increased optimism in company stability.

Buybacks:

A buyback, also referred to as a “share repurchase,” is when a company buys its own outstanding shares to reduce the number of shares available on the open market. Reducing the number of shares outstanding on the market increases the proportion of shares owned by investors, thereby inflating positive earnings per share and, often, the value of the stock.

Buybacks can benefit investors by increasing earnings per share (EPS), as well as increasing share prices. In practice, buybacks reduce the number of assets on a company’s balance sheet but don’t affect the level of profitability, thus increasing the EPS.

Companies might vie to pursue a buyback program if they believe their shares are undervalued after failing to meet expected earnings which might occur in the case of a weakened market. Companies can choose to repurchase shares and resell them in the open market to accurately reflect the value of the company once the EPS increases. Traders who choose not to sell would then have a higher percent of ownership of the company’s shares and a higher price per share, while those who do would have the opportunity to sell at a higher price.

Buyback Tax Benefits:

Buybacks can offer professional traders potential tax benefits, as well. When excess cash is used to repurchase company stock, instead of increasing dividend payments, shareholders have the opportunity to defer capital gains if share prices increase. Traditionally, buybacks are taxed at a capital gains tax rate, whereas dividends are subject to ordinary income tax. If the stock has been held for more than one year, the gains would be subject to an even lower capital gains rate, even under newly proposed tax plans.

Buyback Cash Flow:

In addition to increased share prices and tax benefits, buybacks can contribute to optimism in shareholder sentiment. When companies pursue buyback programs, this demonstrates to investors that the company has additional cash on hand. More importantly, it signals to investors that the company feels cash is better used to reimburse shareholders than reinvest alternative assets. In essence, this supports the price of the stock and provides long-term security for investors.

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