Damodaran Keeps it Simple: Stock Buybacks Explained

Professor Aswath Damodaran recently posted an article titled “Stock Buybacks: They are big, they are back and they scare some people!”. Per his comments:

This post is not aimed at the vast majority of investors who sensibly view buybacks as good or bad on a company-by-company basis but at the shameless boosters of buybacks, who treat it as a magic bullet, at one extreme, and the equally clueless Cassandra chorus, who view it as the market equivalent of the Ebola virus, signaling the end of Western civilization as we know it, at the other.

I recommend you read the article in full. Its long, but if you fall into either category mentioned above, very worthwhile (no one has to know). What I could not resist posting here is his simple explanation of a stock buyback, which highlights the principal differences between buybacks and dividends:

Keep it simple: Buybacks are a return of cash to stockholders

To understand buybacks, it is best to start simple. Publicly traded companies that generate excess cash often want to return that cash to stockholders and stockholders want them to do that. There are only two ways you can return cash to stockholders. One is to pay dividends, either regularly every period (quarter, semiannual or year) or as special dividends. The other is to buy back stock. From the company’s perspective, the aggregate effect is exactly the same, as cash leaves the company and goes to stockholders. There are four differences, though, between the two modes of returning cash.


Dividends are sticky, buybacks are not: With regular dividends, there is a tradition of maintaining or increasing dividends, a phenomenon referred to as sticky dividends. Thus, if you initiate or increase dividends, you are expected to continue to pay those dividends over time or face a market backlash. Stock buybacks don’t carry this legacy and companies can go from buying back billions of dollars worth of stock in one year to not buying back stock the next, without facing the same market reaction.

Buybacks affect share count, dividends do not: When a company pays dividends, the share count is unaffected, but when it buys back shares, the share count decreases by the number of shares bought back. Consequently, share buybacks do alter the ownership structure of the firm, leaving those who do not sell their shares back with a larger share in a smaller company.

Dividends return cash to all stockholders, buybacks only to the self-selected: When companies pay dividends, all stockholders get paid those dividends, whether they need or want the cash. Thus, it is a return of cash that all stockholders partake in, in proportion to their stockholding. In a stock buyback, only those stockholders who tender their shares back to the company get cash and the remaining stockholders get a larger proportional stake in the remaining firm. As we will see in the next section, this creates the possibility of wealth transfers from one group to the other, depending on the price paid on the buyback.

Dividends and buybacks create different tax consequences: The tax laws may treat dividends and capital gains differently at the investor level. Since dividends are paid out to all stockholders, it will be treated as income in the year in which it is paid out and taxed accordingly; for instance, the US tax code treated it as ordinary income for much of the last century and it has been taxed at a dividend tax rate since 2003. A stock buyback has more subtle tax effects, since investors who tender their shares back in the buyback generally have to pay capital gains taxes on the transaction, but only if the buyback price exceeds the price they paid to acquire the shares. If the remaining shares go up in price, stockholders who do not tender their shares can defer their capital gains taxes until they do sell the shares.

What follows is a description of how buybacks influence equity value per share and stock price with helpful visuals: LINK.