And why do people compare using them to the Great Depression stock crash? I don’t understand and I tried.
In: 3
Stocks are owning ‘part’ of a company. You, and X of your new buddies all put up some capital to fund a venture, and are entitled to 1/X of the resulting company. If you and 99 other people each put up 1000$ for a single share in a shop, that shops starting capital is 100,000.
The desire is that these ventures are profitable, and if it is, the most tax-advantaged route is generally for the company to reinvest the profits. So if your shop produces 10K in profit, and they use it to expand the shop, you get increased value in your share.
However, there will be times that it does not make sense to do that. Sometimes a company wishes to expand faster than it can grown on its own, or is in a downturn and needs liquidity. The options are basically taking debt or issuing new shares, and the latter dilutes the ownership (instead of 100 owners, you may now have 200).
On the inverse, if a company has extra cash and doesn’t want to reinvest it, it can pay down debt, issue a dividend, or do a stock buyback. Dividends are simply saying “I have an extra 100$, each shareholder gets 1$”, while a stock buyback is saying “I’m going to buy 100$ worth of stock off the open market in the name of the company.”, after such a buy, there may be only 98 shareholders left, concentrating ownership.
Both stock buybacks and dividends are very beneficial to the functioning of the market as a whole. Just because it makes sense to invest 100K into a business doesn’t mean it makes sense to invest 300K into the same business, and if the business is doing well, it can be generating more in profit than is sensible to invest in that business sector.
It generally gets vilified by people who would rather the company reinvest the profits, creating demand/jobs in the business. It doesn’t mean it isn’t better for the investors to take those profits and invest them in other businesses with more potential.
tl;dr: It is just the inverse of selling new stock to raise capital, it is buying old stock to reduce capital. It is an alternative to giving dividends. Because markets are forward-looking, if the company disagrees with the market on its future prospects (and thus thinks it is ‘undervalued’), there will be more value in a stock buyback than a dividend.
A stock buyback is when a company uses their cash on hand (ie. money from profits) to buy shares and reduce the number of shares that are owned by shareholders. Reducing the number of shares means even flat earnings result in higher earnings per share, so the stock price should go up.
Imagine there was a company with 100 shares. They do a buyback of 10% of their shares. With only 90 shares outstanding after the buyback, each one is now worth 1.11% of the company’s total value instead of 1%.
It’s when the company uses its own cash to buy back the stocks it had issued (and were subsequently sold).
It’s a bad thing for many reasons.
– It artificially inflates the price of the stock. Executives do this so their stock grants/options are worth more. Long term Capital gains on stock can be taxed at no more than 20%, but income can be taxed at up 37%
– it depletes the cash reserves of the company. We saw this at the beginning of COVID when a couple of airlines did some huge stock buybacks. The airlines were out of cash and couldn’t handle the sudden drop in revenue. So, of course, they went begging for a handout.
This trick was done during the Great Depression to fluff up stock prices so the corporate managers had more money but lower workers were laid off because of no cash reserve.
Stock buybacks were outlawed shortly thereafter, but under President Reagan, the SEC threw out those rules.
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