It’s hard to read the WSJ these days without hearing something about buybacks. Exxon absorbing $102 billion, Citigroup spending $8.3 billion and even Coach buying back $1 billion. Stock buybacks or share repurchases are known to have powerful effects in building shareholder wealth. To many, it’s often an overlooked measure of the health of a company, trailing stock price appreciation and dividend payouts. The basic theory behind buybacks is that once the shares are absorbed by the company, the value of each outstanding share increases because there are fewer shares floating in the market.

In the three years ending 2007, companies have bought back around $1.32 trillion in shares, whereas capital expenditures totaled $1.28 trillion and dividends totaled $0.6 trillion.

Why are buybacks so alluring? According to Jason Zweig of WSJ, stocks regularly jump up 3-6% on the announcement of a buyback. Most management opt for buybacks because it’s a way infuse positivity among investors, and keeps the company’s stock growing.   As investors, it’s hard to control our urge to get into a company knowing that management has 110% belief in the firm. The theory is good, but the case does not often play out as nicely as you hope.  

Not As Noble As You Think

While buybacks as a whole may have helped boost returns to stock market investors as a class, companies often don’t use them just to demonstrate that their stocks are undervalued, or to distribute wealth to shareholders.

Another reason why management typically executes buybacks is to prop up the financial ratios, as buybacks reduce the assets and equity of the company, making the ROA and ROE look better. In addition, the P/E looks better because of the fewer number of shares.

Buybacks also help reduce dilution of earnings as many analysts have previously purported, or do they? How can buybacks be anti-dilutive? Many buyback are often financed through borrowing, and while this often has tax advantages, companies are simply replacing equity with debt; so if the subsequent share price return is below the cost of debt, buybacks are actually destructive of earnings. Similarly, if buybacks are financed entirely through cash, the opportunity cost associated with cash may be higher than the value generated through the buyback.

A final reason why companies do buybacks is to offset the growing numbers of options they issue to their employees. If a company buys back 10MM shares but issues 10MM share to employees as options, the net result may indeed be unfavorable. The reason is that options are often cashed out by employees for less than the market price under company option programs. Companies essentially buy back shares at a higher price than they issue them. Buying high and selling low is not by any means sustainable, but many companies seem to have adopted this strategy lately. For example, buybacks hit an all-time high of $172 billion in Q3 2007, just before the credit crisis; not the greatest investment.

Next time a company announces a buyback, play smart money and analyze the situation thoroughly before diving in. Is it really a good deal for investors or is management simply trying to manipulate the stock?

Disclosure: None