Why are share buybacks so popular?
When companies have extra cash, they can pay dividends to shareholders, buy back shares (also called stock repurchases), invest the money back into the company, or a combination of both, which is generally the case.
Companies often choose buybacks over dividends because there are several advantages.
1. The company increases its earnings per share ((EPS)) by reducing the number of outstanding shares.
This also lowers the price-to-earnings (P/E) ratio, which usually pushes the stock price higher. In short, it makes the company’s results look great and gives us investors a bigger slice of the pie.
2. Stock buybacks have massive tax benefits for shareholders who hold investments in taxable accounts.
Qualifying dividends are taxed at the long-term capital gains tax rate, which is 0%, 15%, or 20% depending on the tax bracket. The 15% tax rate applies to most people because it covers incomes between $41,675 and $459,750 for single parents.
Companies protect investors from this tax by using extra money for buybacks instead of dividends. This way investors will not have a chargeable event until they sell the Shares.
There are other added benefits, but let’s not get completely bogged down in weeds.
What is the New Consumption Tax on Share Buybacks?
The US corporate tax rate has changed many times in its history. It is now 21%, the lowest since the 1940s. Prior to the Tax Cuts and Jobs Act of 2017, the tax rate had been 35% since 1993 and much higher since the 1950s.
This has caused some companies to hoard cash and explode in share buybacks — something that is hailed by shareholders and frowned upon by some people and politicians. Total buybacks in 2021 were around $850 billion.
With apple (NASDAQ:AAPL) groundbreaking.
The new tax appears to be fairly simple — a 1% excise tax on the value of share buybacks payable by the company.
How will the new tax affect Apple and its shareholders?
Apple is buying back its stock at an incredible pace. Buybacks will total nearly $385 billion over the past five fiscal years once 2022 is on the books, as shown below.
$385 billion is nearly 14% of Apple’s current market cap.
The stock’s price has skyrocketed as the outstanding shares have shrunk significantly as shown below.
The new tax would cost Apple about $860 million annually at the current rate of buybacks.
Apple reported net income of $94.7 billion for fiscal 2021. The 1% buyback tax would reduce that to about $93.8 billion. It would also reduce diluted earnings per share from $5.61 to about $5.56 as shown below.
Apple stock currently trades at 30.7 times fiscal 2021 EPS. Applying the same ratio to the lower EPS number would theoretically drop the stock price by about $1.50 — hardly a market-moving number.
Of course it’s not that simple. Many other metrics that investors use to evaluate stocks aren’t affected at all, so the stock price isn’t destined to fall by any specific amount.
What options does Apple have?
Apple has several maneuvers it can make.
First, companies will likely accelerate significantly Buybacks until the end of 2022 as the tax will not take effect until 2023.
Next, many have suggested that companies simply buy back 99% of the projected amount and use the 1% saved to pay the tax. This is a great plan when cash flow is the primary concern. But it will still slightly hurt net income and earnings per share.
Apple could also decide to increase the dividend and decrease buybacks. This reduces the company’s tax burden. But it has two major disadvantages. First, the share count won’t be shrinking anytime soon, so earnings per share will still be hurt. Second, the tax burden is essentially shifted to shareholders. This is compounded by the fact that many shareholders pay 15% tax on those dividends — well above the 1% consumption tax rate.
So what’s the bottom line?
It boils down to finding the most beneficial way to reward shareholders with billions of dollars in free cash flow – what an excellent problem!
The tax is likely to have a minor negative impact on shareholders in companies that spend huge sums on buybacks. On the other hand, the corporate tax rate is still the lowest it has been in many decades, and stocks remain prime vehicles for wealth creation.
The best course of action for Apple is to continue with business as usual and pay the 1% tax for shareholders.