Your Company Did a Terrible Thing

Editor's note: A previous version of this article mistakenly included Cypress Semiconductor in the initial table. The Fool regrets the error.

Share buybacks may seem like a shareholder-friendly use of capital, but unless it's done properly, the practice can be about as advisable as spitting in Tony Soprano's spaghetti.

Prior to the recession, it seemed like pretty much every company out there was buying back shares hand over fist. For a while, every day seemed to bring a new billion-dollar share buyback plan -- and the market cheered it all on.

But was it smart?
For a great many companies, I'd say, it wasn't smart. Take a gander at the massive buybacks the following companies made in 2007 only to see their stocks plummet as we headed into the downturn.

Source: Capital IQ (a division of Standard & Poor's).

Now before you start hootin' and hollerin' that I'm being unfair to your company, I will point out that the stocks may have been beaten down too far by the market and the big buybacks may still prove to have been a good idea.

However, I don't think it's simply coincidence that these stocks have fallen much more than the rest of the market. Instead, I think management did a poor job deciding how to use the company's capital and paid too much to buy back shares. In some cases, like Macy's, management ignored the big valuation that the company's stock was carrying and bought shares anyway. In others, such as Valero, management seemed to ignore the fact that the company operates in a highly cyclical industry and that it was buying stock during peak times.

For investors, the performance of a company's stock following share buybacks isn't just footnote material. That's your money that management is using to buy that stock, and if they're overpaying for that stock, then they're wasting your money.

Why do it then?
I find it hard to believe that any management team set out to waste money for the sheer joy of it. There are a handful of reasons that share buybacks might look good to a CEO even if it isn't the best option for shareholders. Here are a few.

1. Increasing earnings per share: Buying back shares reduces the number of shares outstanding and therefore increases earnings per share. Managers can use buybacks to help meet Wall Street expectations and give the illusion that the company is growing faster than it is.
2. Boosting the share price: Higher earnings per share, as well as the excitement that can be generated from the announcement of a major buyback, can push up share prices. Unless the buyback was done wisely, this is only a short-term benefit for shareholders since value has been destroyed. For managers who own piles of stock options, on the other hand, even a short-term boost in the stock price can be very lucrative.
3. Ignorance: Just because someone is a good business manager doesn't necessarily mean they're a good capital allocator. A manager who's a poor allocator of capital may decide to do a share buyback without doing an adequate analysis of whether it actually makes sense.

The bottom line is that there are a great number of managers out there squandering shareholder capital by making lousy investments in company stock. Making it all worse is that investors have more often than not cheered these managers on.

They can't all be Buffett
For Warren Buffett, the process of building Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) has been a process of taking all of the cash generated by the operating businesses that the company owns and finding the most rewarding places to invest that capital. Sometimes that's acquiring new operating businesses, sometimes it's encouraging more insurance contracts to be written, and sometimes it's investing in huge public companies like Goldman Sachs (NYSE:GS) and General Electric (NYSE:GE).

Berkshire doesn't pay a dividend and doesn't buy back stock because Buffett believes he can always find more rewarding ways to use shareholder capital.

Most CEOs are not Warren Buffett, though. And that's not necessarily a bad thing. In most cases the chief executives are at the top because they know their businesses inside and out and are in the best position to lead the companies to growth and operational success. But they still need to choose highest-return investments for your capital.

When in doubt
There are really only a handful of options for using the cash produced by a business: organically expanding the business, making acquisitions, paying down debt and improving the balance sheet, paying a dividend, and repurchasing stock. Assuming there aren't extenuating circumstances like dangerously high debt levels, the math should be easy -- choose the option that provides the best return.

Good business operators generally have a very good grasp on what kind of returns can be expected if money is invested back into the business to drive growth. Most of the time -- though maybe not often enough -- they're also good at evaluating the returns that can be had by acquiring another compatible business.

But what if those both promise unattractive returns? This is where problems generally arise. Too many managers these days think that their fancy MBAs give them license to get cute with shareholder capital. This is why we end up with nonfinancial companies investing in risky debt or stocks, buying businesses outside of their core competency, and making ill-advised share buybacks.

Once we get out a nice big dictionary and whack these overreaching CEOs over the head with it, we can tell them exactly what to do with that extra money. The answer is simple: Give the money to the owners of the company. Shareholders are investors, and investors are capital allocators. When reinvesting in the operating business doesn't make sense, and shares are not undervalued, it's time to give the money back to shareholders in the form of dividends so they can find a better place for it.

If you're fed up with management teams squandering the capital of the companies you own and are ready to own companies that put that money back in your pockets, you may want to check out the Motley Fool Income Investor newsletter. The advisors at Income Investor are dedicated to finding the very best dividend-paying companies that understand that you should end up with profits that aren't reinvested because you are a co-owner of the business. Better still, you can check out the newsletter's stock recommendations free for 30 days by simply clicking here.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, but does not own shares of any of the other companies mentioned. Berkshire Hathaway is both a Motley Fool Stock Advisor and Motley Fool Inside Value selection. The Fool owns shares of Berkshire Hathaway. The Fool's disclosure policy thinks shareholders deserve their own money just like Michael Vick deserves ... well, let's just leave it at shareholders deserve their money.