Are Share Buybacks Good?

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With business perking up, American corporations are sitting on huge piles of cash, and Standard & Poor’s predicts that S&P 500 companies will use a lot of that to buy back their own shares.

In fact, S&P says more money will be spent on buybacks than dividend increases.

So, from the shareholder’s point of view, is this good? It can be, but buybacks can also be a warning sign.

Buybacks are sort of the opposite of stock splits and new share issues, reducing the number of shares in circulation rather than increasing them. A given level of earnings therefore produces higher earnings per share. That should push the stock price up, since price is generally some multiple of earnings.

If a company earned $5 per $100 share, the price-to-earnings ratio would be 20. Reduce the number of shares by half through buybacks and earnings would be $10 per share, and if the price-to-earnings ratio remained at 20, the share price would rise to $200.

So, in the simplified, textbook case, buybacks are good for shareholders. Buybacks plunged in the depths of the financial crisis but started to rebound late last year, and cash hoards have since grown even larger, making more buybacks likely, S&P says.

For shareholders, the issue is whether a buyback is really the best use for that money.

One alternative is a dividend increase. Depending on your situation, this may be preferable because it puts cash in your pocket that could be spent, saved or invested in some way other way. Extra value received through a buyback is at risk of a fall in the share price.

A company may prefer a buyback because it is a one-time move that does not tie the company’s hands in the future.  A dividend increase can be reversed, but that often upsets shareholders and makes it look like the company is in trouble.

Money spent on a buyback obviously cannot be used for other purposes like plant expansion or research and development. Critics sometimes charge that a buyback thus means the managers and board don’t have any good ideas for growing the business.

They may also question whether the company’s own stock is the most promising available. A buyback can enrich company executives and board members who may be required to own a lot of shares, while outside shareholders may prefer, at that moment, to invest in something else.

On the other hand, a buyback can be kinder to the investor at tax time, as the increased share value is not taxable until the shares are sold, while dividends are taxed the year they are received.

For the shareholder, assessing a buyback really depends on what you would do if the company simply set you a check for your share of its surplus cash. If you’d spend it on more shares of the same stock, you should be perfectly happy with the buyback. If you’d rather spend it or invest in something else, a dividend would be better.

Sometimes, of course, companies split the difference. IBM (Stock Quote: IBM) recently announced a hefty 18% dividend increase coupled with an $8 billion buyback.

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