Most investors view stock buybacks as positive. I don’t. I’ll explain why in a minute, but first let’s look at the math and why investors usually stand up and cheer when a buyback is announced.

If a company has 10 million shares outstanding and earns $10 million per year, its earnings per share (EPS) is $1 ($10M/10M shares). If the stock has a price-to-earnings ratio (P/E) of 15, the stock will trade at $15 ($1 in EPS x 15 P/E).

When the company buys back 1 million of its shares, it still earns $10 million per year in profit, but now that $10 million is divided by 9 million shares instead of 10 million.

[ad#Google Adsense 336×280-IA]So although the company didn’t earn any more money, earnings per share rises to $1.11 ($10M/9M shares).

If the stock continues to trade at a P/E of 15, the stock climbs to $16.65.

Look at what just occurred.

There was no change in the company’s business, but through a reduced share count, earnings per share and the stock price jumped 11%.

What’s the Problem?
When a company has extra cash, it can buy shares of its own stock to increase EPS and, theoretically, its share price, which is good for shareholders. So what’s my problem with buybacks?

I’ve got two of them.

First, I’d rather see the cash returned to shareholders in the form of a dividend.

If the company isn’t investing the cash into its business, give it back to me. Let me decide what to do with it. I’ll make the determination if the stock is a good value. If it is, I’ll buy more shares, usually by reinvesting the dividend. If the stock is not a good value, I’ll use the cash for something else.

But I don’t want the executives deciding whether the stock is a good value. Especially because, my second problem, management teams, particularly of large cap stocks, have a terrible track record when it comes to buying back shares of their companies.

Here’s what I mean:

According to a study conducted by Azi Ben-Rephael, Jacob Oded and Avi Wohl and published for the Center for Financial Studies, small cap companies often buy back their shares at below-average market prices. But large cap companies typically buy above market averages. According to the authors, that’s because the large cap companies are more interested in the disbursement of cash than in buying the stock at a good value.

Supporting that theory is the fact that in the first quarter of 2014, management teams spent the second-highest amount ever in buying back their own shares – five years into a bull market. Where were they in 2009 or 2010 when their stocks were in the gutter? Buybacks in the first quarter of this year were higher than they were for all of 2009.

The only other time management repurchased more stock was in the third quarter of 2007. The market peaked a month later.

Executives are people too. They have the same emotions as other investors and piled money in at the top. And when things were scary at the bottom, they held tightly on to their cash, rather than deploying it and creating value for their shareholders.

So now that management teams are loading up the truck with their own shares, I am a bit worried. It’s not a positive sign for the markets and is probably even worse if you’re a shareholder of the company that’s buying back its shares at the exact wrong time.

Good investing,

Marc

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Source: Investment U