Understanding share buybacks

May 17, 2011

Shareholders often get excited when their companies announce share buyback programs. If a company reduces shares in the marketplace, an investor’s share of the company goes up. So that's good, right? Usually, it is, but sometimes it can be a sign that the company is in trouble.

Let's look at the pros and cons. On the positive side:

  • Buybacks enhance the opinion that companies believe in themselves, that they’re willing to bet more on themselves than others.
  • In economic times like now, when borrowing costs are historically low, companies can borrow cheaply to buy back even more shares.
  • If a company reduces shares in the marketplace, an investor’s share of the company goes up. Fewer shares mean price/earnings ratios decline, which can make shares more attractive to buyers. 

On the negative side:

  • Buybacks may signal wider economic problems. Companies sometimes announce buybacks to boost confidence in the overall stock market. That was evident after the crash of 1987 and the market decline beginning in 2008.
  • Investing in oneself may mean prospects for new business and acquisitions have faded.
  • Buybacks can help make certain financial ratios look better. If that’s the primary purpose for a buyback, that may mean the company is buying for the wrong reason. It hints at poor management instead of great prospects.
  • Two of the best ways to enhance shareholder value are share buybacks and higher dividends. To many, share buybacks pale when compared with dividend increases that put more cash in their pockets.
  • Share buybacks are hard to track. Companies have been known to announce a buyback to boost share prices in the short term, then take years to complete it, nullifying the positive impact.

While Greg can list more negatives than positives, he thinks share buybacks are usually a good thing. But he warns us not to assume that they always raise share prices or have a great impact over the long run.