August 14, 2023

In our last piece, we explained how stock buybacks generally work, and why we prefer investing in a globally diversified investment portfolio over chasing or fleeing particular buyback opportunities. Next, let’s look at how companies use stock buybacks in practice.
Broadly speaking, stock buybacks are meant to deliver value to a company’s shareholders in two potential forms:
At the same time, your company (if you’re a shareholder and/or an employee) must spend some of its retained earnings during a buyback, or potentially even take on debt. Clearly, this leaves less cash in the company coffers for other purposes.
As such, a stock buyback represents a trade-off between two opposing forces: enhancing shareholder returns, versus preserving enough capital to continue delivering solid value moving forward.
A company’s management, its employees, and its investors should typically want to strike an appropriate balance between sustaining current and future value. Stock buybacks can (but don’t always) help make this happen.
How and when does a company decide a stock buyback represents shareholders’ best interests, and the best use of its capital? There are a number of reasons a company may embark on a buyback offer.
One argument goes: If a company has more cash than it really needs, a buyback may make more sense than spending the money mindlessly, at the ultimate expense of its shareholders. Here’s how The Wall Street Journal columnist Jason Zweig has described it:
“Expecting oodles of surplus cash not to burn a hole in the typical CEO’s pocket, however, is like putting a pile of raw meat in front of a lion and expecting it not to disappear. My favorite examples come from the 1970s, when—just like now—giant oil companies had vastly more capital than they could plow back into their existing wells.”
So far, we’ve summarized the ways stock buybacks can be an effective tool in the right hands, delivering powerful, tax-efficient value to shareholders, without necessarily stunting future growth. In our next piece, we’ll look at how this same power tool can end up being weaponized in the wrong hands, and why the government is keeping an eye on the practice.