Why do companies buy back shares? The pros and cons for shareholders 

There are many reasons why someone may invest in a company, whether it’s to earn extra income via dividends or to benefit from the firm’s long-term growth. 

Companies can deliver value to shareholders in many ways, one of the most common being dividend payments. 

However, they can also use share buybacks to deliver value to shareholders, which we’ll explore in this article. 

What is a share buyback? 

A share buyback is when a company uses its cash to buy back its shares from the open market from any shareholders who are happy to sell. 

The shares are then cancelled, reducing the number of shares in circulation. 

This can benefit shareholders in many ways, including giving them a bigger stake in the company, driving up the share price, and offering better returns on dividends in the future. 

Over the last few years, share buybacks have become more popular with UK companies as share prices have been seen as typically undervalued.  

A share buyback helps a company address this issue instead of waiting for investor sentiment to change amid general economic uncertainty. 

According to Schroders, 38% of large US companies bought back at least 1% of their shares in 2023, while large UK companies almost matched the US for the second year running. 

Historically, US buyback activity has been far higher than in other markets, but this appears to be changing. 

The proportion of UK companies doing bigger buybacks was higher than the US in 2023, with 13% of large UK firms buying back at least 5% of their shares compared to the US.  

Why would a company do a share buyback? 

If a company believes its shares are undervalued, a share buyback can help by driving up the value of the remaining shares.  

Companies can only pay dividends if they make a profit and tend to introduce payouts so they can continue making them in the future. 

When businesses have historically cut or even ditched their dividends, their share price has taken a huge hit. 

A share buyback doesn’t require a company to be profitable and can be used if it has extra cash, and it can be taxed at a lower rate than dividends.  

What are the pros and cons of share buybacks? 

There are many advantages and disadvantages to share buybacks. 

The pros of share buybacks: 

•  The company’s share price tends to rise: As the number of shares is cut but the firm’s value is unchanged, the share price will usually increase. This will help address concerns that shares in the company are undervalued and show management is confident in its future.
• Share buybacks can be one-off: When a company pays a dividend, they commit to paying these over the long term, but this isn’t necessary with a share buyback. 
• Shareholders have a bigger stake: As fewer company shares exist, the earnings per share (EPS) rises, so shareholders have a bigger stake and can get more profits.  
• There are no tax implications (if you do nothing): If you simply do nothing, you won’t pay any tax, which differs from dividends as these are taxed as income. Of course, if an investor does sell their shares, they may be liable for capital gains tax (CGT). 

The cons of share buybacks: 

• The EPS impact: While a higher EPS can be positive for shareholders, it can sometimes be linked to management bonuses, so a share buyback can trigger these. If this happens, it can raise doubt about why the company decided to buy its shares back. 
• Share buybacks can be funded by debt: If this is the case, it can harm the company’s balance sheet and possibly its long-term prospects, especially if interest on the debt is high. 
• Share buybacks tend to happen when stock is expensive: Companies have historically done share buybacks amid a bull market (when stock prices rise over 20% from a recent low) instead of a bear one (when stock prices fall over 20% from a recent high). However, it makes more sense to buy back when company stock is cheap. 
• They don’t always work and may be criticised: Millions can be spent on share buybacks, but that doesn’t always translate into a higher share price. Share buybacks can also come under fire if they are not believed to be the best investment. For example, BP has been criticised for prioritising shareholders over investing in renewable energy. 

While share buybacks can be positive for the company and shareholders, it’s good to understand why these happen and whether it’s the best option. 

For example, you should consider if there is a better use for that excess cash and if you are aligned with how the company plans to grow in the future and deliver value for shareholders. 

Need guidance with your investment strategy? 

Investing can be difficult, but it doesn’t need to be. 

Unbiased can match you with a qualified financial adviser who can help you with your investment strategy, including guidance on creating a portfolio to match your future goals and risk appetite.