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Stock buybacks are a double-edged sword. By reducing share counts, they can boost the value of each remaining share. But if management buys back shares at too high a price, it's effectively destroying value. Worse yet, spending money on buybacks and dividends can also rob companies of other opportunities.
A company can do any number of things with the money it earns: Pay down debt, buy another company, build another factory, hire more workers, buy more advertising, pay out a dividend, buy back shares, or just let the money pile up. Great companies use their dollars wisely.
If a company pays a dividend or buys back shares at a fair price, shareholders will profit. But neither of those steps will make the company bigger, stronger, or better positioned. Devoting that money toward building the business instead might ultimately benefit shareholders even more. That's why Warren Buffett has resisted paying a dividend for so long. Letting cash pile up has permitted him to make the occasional huge purchases for which he's famous.
Coffers and offers
Cisco Systems (Nasdaq: CSCO ) spent nearly $8 billion buying back shares in fiscal 2010, and has spent $65 billion over the past decade. It recently announced plans to initiate a dividend, which will cost it between $1 billion and $3 billion annually. The company recently had about $40 billion in cash and short-term investments, so these sums won't cripple it. But it might be able to use those big sums to do big things.
Some investors have suggested that Cisco might buy Research In Motion (Nasdaq: RIMM ) , recently valued around $27 billion, to bolster its presence in the wireless phone arena. Research In Motion's smartphones appeal primarily to business users, meshing well with Cisco's strong focus on corporate customers.
Similarly, Oracle (Nasdaq: ORCL ) spent about $10 billion on share repurchases during its 2007 to 2009 fiscal years. There's talk that it might buy EMC (NYSE: EMC ) to strengthen its storage capacity and virtualization software chops. But since Oracle recently had only about $24 billion in cash, compared to EMC's market cap of $44 billion, Oracle might have to issue more stock to fund such a purchase.
The big picture
These and other companies' buyback and dividend moves aren't necessarily dumb. In the current economic environment, big and healthy companies can borrow large sums of money for very little, giving them greater flexibility. But few companies will qualify for the best deals. And in any economy, it's useful to think about exactly how a company is spending its cash, and whether it's losing out on any more attractive opportunities in the process.
Some dividends are not just suboptimal -- they're downright crazy!