Why investors like Warren Buffett are so fond of stock buybacks

Corporate America still loves stock buybacks. Warren Buffett spent a significant chunk of his annual letter, published Saturday, praising them — which is just as well, given that 2023 is likely to be the first year where they reach $1 trillion.

Why it matters: Buybacks, which were illegal until 1982, are now taxed at 1%. The change enacted two months ago is estimated to raise $74 billion over a decade for the public fisc. So far, the tax doesn't seem to have reduced their popularity in the slightest.

The big picture: As Buffett explains, the theory behind buybacks is that they reduce the number of shares outstanding, thereby giving each remaining shareholder ownership of a greater percentage of the company.

• The catch: Buybacks cost money — sometimes too much money.
• Even Buffett doesn't like all buybacks. In something of a tautology, he says he only likes the ones made "at value-accretive prices" — which is to say, he thinks buybacks create shareholder value only when they create shareholder value. Thanks, Warren.

Where it stands: Shareholders expect to receive corporate profits one way or another — which is to say, either through buybacks or via dividends.

• Investors who pay taxes generally prefer buybacks, because dividends are taxable as income. Buybacks, on the other hand, generate no tax bill for any non-selling shareholder — and even selling shareholders generally only pay the lower long-term capital gains tax.
• The new tax on buybacks is not a so-called Pigovian tax on something the government disapproves of and wants less of, so much as it's a way to try to even out distortions in the difference between how dividends and buybacks are taxed.

Executives also have good reasons for preferring buybacks to dividends.

• For one, when employees are granted options, buybacks effectively increase the proportion of the company that they're entitled to purchase at a fixed price, making the options more valuable. Dividends, by contrast, just reduce the amount of money in the company, making options less valuable.

Driving the news: Goldman Sachs announced Friday that it has spent $2.25 billion buying back its own shares so far this year and that it was authorized to spend another $30 billion in the future. That's roughly 25% of its current market value.

• Even bigger buyback announcements have come from Meta ($40 billion) and Chevron ($75 billion).

Between the lines: Buybacks are a weak signal that executives think the stock is undervalued. Dividends send a different, but equally positive, message: That the company is confident of being consistently profitable far into the future.

The bottom line: Buybacks are a form of financial engineering; often they're paid for not out of profits but from borrowing money in the debt markets. Taxing them just makes the financial engineering a tiny bit more complicated, without making any major changes to the way that companies try to make their shareholders richer.