Buying back shares can be a sensible way for companies to use extra cash.

But in
many cases, it's just a ploy to boost earnings and, even worse, a signal that t
he company has run out of good ideas. This means that investors can't afford to
take buybacks at face value. Find out how to examine whether a buyback represent
s a strategic move by a company or a desperate one.
When Buybacks Work
A share buyback happens when a company purchases and retires some of its outstan
ding shares. This can be a great thing for shareholders because after the share
buyback, they will own a bigger portion of the company, and therefore a bigger p
ortion of its cash flow and earnings.
In theory, management will pursue share buybacks because they offer the greatest
potential return for shareholders - a better return than it could get from expa
nding operations into new markets, investing in the brand or any of the other us
es that the company has for cash. If a company with the potential to use cash to
pursue operational expansion chooses instead to buy back its stock, then it cou
ld be a sign that the shares are undervalued. The signal is even stronger if top
managers are buying up stock for themselves. (To learn more, read How Buybacks
Warp The Price-To-Book Ratio.)
Most importantly, share buybacks can be a fairly low-risk approach for companies
to use extra cash. Re-investing cash into, say, R&D or new a new product can be
very risky. If these Investments don't pay off, that hard-earned cash goes down
the drain. Using cash to pay for acquisitions can be perilous, too. Mergers har
dly ever live up to expectations. Share buybacks, on the other hand, let compani
es invest in themselves when they are confident their shares are undervalued and
offer a good return for shareholders. (For more, see how you can Use Breakup Va
lue To Find Undervalued Companies.)
When Buybacks Fail
Some of the time, share buybacks can be a great thing. But oftentimes, they can
be a downright bad idea and can hurt shareholders. This can happen when buybacks
are done in the following circumstances:
1. When Shares Are Overvalued
For starters, buybacks should only be pursued when management is very confident
the shares are undervalued. After all, companies are no different than regular i
nvestors. If a company is buying up shares for $15 each when they are only worth
$10, the company is clearly making a poor investment decision. A company buying
overvalued stock is destroying shareholder value and would be better off paying
that cash out as a dividend, so that shareholders can invest it more effectivel
y. (Find out what dividends can do for your portfolio in The Power Of Dividend G
rowth.)
2. To Boost Earnings Per Share
Buybacks can boost EPS. When a company goes into the market to buy up its own st
ock, its decreases the outstanding share count. This means that earnings are dis
tributed among fewer shares, raising earnings per share. As a result, many inves
tors applaud share buybacks because they see increasing EPS as a surefire approa
ch to raising share value.
But don't be fooled. Contrary to popular wisdom (and, in many cases, the wisdom
of company boards), increasing EPS doesn't increase fundamental value. Companies
have to spend cash to purchase the shares; investors, in turn, adjust their val
uations to reflect the reductions in both cash and shares. The result, sooner or
later, is a canceling out of any earnings-per-share impact. In other words, low
er cash earnings divided between fewer shares will produce no net change to earn
ings per share.
Of course, plenty of excitement gets generated by the announcement of a major bu
yback as the prospect of even short-lived EPS can gives share prices a pop-up. B
ut unless the buyback is wise, the only gains go to those investors who sell the
ir shares on the news. There is little, if any, benefit for long-term shareholde
rs. (For more insight, see How To Evaluate The Quality Of EPS.)
3. To Benefit Executives
Many executives get the bulk of their compensation in the form of stock options.
As a result, buybacks can serve a goal: as stock options are exercised, buyback
programs absorb the excess stock and offset the dilution of existing share valu
es and any potential reduction in earnings per share.
By mopping up extra stock and keeping EPS up, buybacks are a convenient way for
executives to maximize their own wealth. It's a way for them to maintain the val
ue of the shares and share options. Some executives may even be tempted to pursu
e share buybacks to boost the share price in the short term and then sell their
shares. What's more, the big bonuses that CEOs get are often linked to share pri
ce gains and increased earnings per share, so they have an incentive to pursue b
uybacks even when there are better ways to spend the cash or when the shares are
overvalued. (Learn more in the Pages From The Bad CEO Playbook.)
4. Buybacks That Use Borrowed Money
For executives, the temptation to use debt to finance earnings-boosting share pu
rchases can be hard to resist, too. The company might believe that the cash flow
it uses to pay off debt will continue to grow, bringing shareholder funds back
into line with borrowings in due course. If they're right, they'll look smart. I
f they're wrong, investors will get hurt. Managers, moreover, have a tendency to
assume that their companies' shares are undervalued - regardless of the price.
When done with borrowing, share buybacks can hurt credit ratings, since they dra
in cash reserves that can serve as a cushion if times get tough.
One of the reasons given for taking on increased debt to fund a share buyback is
that it is more efficient because interest on debt is tax deductible, unlike di
vidends. However, debt has to be repaid at some time. Remember, what gets a comp
any into financial difficulties is not lack of profits, but lack of cash.
5. To Fend Off an Acquirer
In some cases, a leveraged buyback can be used as a means to fend off a hostile
bidder. The company takes on significant additional debt to repurchase stocks th
rough a buyback program. Such leveraged buybacks can be successful in thwarting
hostile bids by both raising the share value (hopefully) and adding a great deal
of unwanted debt to the company's balance sheet.
6. There Is Nowhere Else to Put the Money
It's very hard to imagine a scenario where buybacks are a good idea, except if t
he buybacks are undertaken when the company feels its share price is far too low
. But, then again, if the company is correct and its shares are undervalued, the
y will probably recover anyway. So, companies that buy back shares are, in effec
t, admitting that they cannot invest their spare cash flow effectively.
Even the most generous buyback program is worth little for shareholders if it is
done in the midst of poor financial performance, a difficult business environme
nt or a decline in the company's profitability. By giving EPS a temporary lift,
share buybacks can soften the blow, but they can't reverse things when a company
is in trouble. (Learn more in Cash-22: Is It Bad To Have Too Much Of A Good Thi
ng?)
Conclusions
As investors, we should look more closely at share buybacks. Look in the financi
al reports for details. See whether stock is being awarded to employees and whet
her repurchased shares are being bought when the shares are a good price. A comp
any buying back overvalued stock - especially with lots of debt - is destroying
shareholder value. Share repurchase plans aren't always bad. But they can be. So
, let's be careful out there. (For more, see A Breakdown Of Stock Buybacks.)