Stock Buybacks to Be Wary Of

According to a recent survey from Audit Integrity, companies with "aggressive accounting" practices tend to give managers generous stock-option packages and use share-buyback programs.

The survey of some 7,000 companies also found that nearly half rated as "very aggressive" in those practices. Of the companies rated as conservative in their accounting, only 6% offered share-repurchase programs.

Among the companies that Audit Integrity rated as "very aggressive":

• Parker Hannifin (NYSE: PH)
• KLA-Tencor (Nasdaq: KLAC)
• CA (Nasdaq: CA)
• Alliance Data Systems (NYSE: ADS)
• Mirant (NYSE: MIR)
• Marchex
• Cisco Systems (Nasdaq: CSCO)
• Amgen (Nasdaq: AMGN)

If a company's stock is significantly undervalued, the company can put some of its excess cash to good use by buying back and essentially retiring many shares. That can benefit shareholders, by reducing the number of shares outstanding and increasing the value of the remaining shares. Think of a pizza being cut into six pieces instead of eight.

There is, though, a scenario in which buybacks aren't ideal. If a company is issuing gobs of stock to employees, that will raise the share count and dilute the earnings per share, which will make the company's earnings reports less stellar. So some companies buy back shares to offset that share increase and don't necessarily pay much attention to whether the shares are undervalued.

As investors, we should look more closely at stock repurchases. Look in the financial reports for details. See whether stock is being awarded to employees and whether repurchased shares are being bought at good prices. A company buying overvalued stock is destroying shareholder value and would be better off paying that cash out as a dividend, so that people can invest it more effectively.

Share-repurchase plans aren't always bad. But they can be misused -- and so we should be vigilant.

Although share buybacks are used to boost stocks, many investors prefer dividend-paying companies that put cash back in your pocket. Try out our Income Investor newsletter service free for 30 days, to see a long list of recommended dividend payers.