Stock buybacks, in which companies take their own shares off the market by buying out the investing public don't always pay off for shareholders.
Companies must find ways to put their excess cash to use. When the market price of a company's stock is lower than the "intrinsic value" of its business—the present worth of the cash it will generate in the future—then the company should buy back all the shares it can.
But buybacks are far from an exact science. At their worst, buybacks can be a form of corporate cannibalism. Often the unspoken motive is to use extra cash to boost earnings per share by reducing the number of shares among which the company's profits are divided. But that can be a slippery slope.
But are investors better off? Imagine two companies, each with $100 in cash and 10 shares of stock. The intrinsic value of each is $10 a share. But the stock market undervalues one company's shares at $5 apiece and overvalues the other at $20. Each company decides to buy back $10 worth of stock. The undervalued company gets to buy back two shares at $5 each, leaving $90 in assets spread across eight shares. That raises the intrinsic value of each share to $11.25. The overvalued company uses $10 to buy back half a share, leaving the same $90 in assets spread across 9½ shares. That lowers the intrinsic value of each remaining share to $9.47.
So how can you spot a bad buyback? Here is a red flag: If cash is dwindling as buybacks are growing, the firm may be starving future growth to pay off present shareholders. That is fine if you sell into the buyback. But it is bad if you hang onto your shares. Owning a bigger piece of a corporate cannibal may leave you hungry in the long run.