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The Skinny on Share Buybacks

Every company would love to have mountains of free cash. But one question inevitably arises from investors when a company has lots of cash on the books: What are they going to do with it?

Companies generally have three choices in this situation:

  1. Reinvest it in the business.
  2. Pay it out to shareholders.
  3. Buy back shares on the open market.

It's the third option, buying back shares, that I want to examine today -- and with it, the myth that every company that announces a share repurchase plan is trading on the cheap.

Do buybacks enhance shareholder value?
Share repurchases have been increasingly popular in recent years. Recently, Barron's mentioned that average annual dividend payments at companies have doubled to just over $500 million since 2002, while share repurchases over the same time frame have tripled to just over $600 million.

Many times, these plans can work out very well for investors. By buying back its common stock, a company increases its earnings per share as well as other important metrics, such as return on equity (ROE) and return on invested capital (ROIC). But does this really make a company more valuable? No, not really.

Do buybacks mean a stock is cheap?
But there's a line of thinking in the investment world that any time a company announces a share repurchase plan it believes its shares are undervalued. Back in 2000, for example, Warren Buffett famously announced that he would repurchase Berkshire Hathaway (NYSE: BRKb  ) stock, the first and only time he has made such a statement. Investors took this to mean that Buffett believed his shares were undervalued, and they immediately bid up the stock as a result.

But is this always the case? No.

A major buyback can be a red flag that a company is running out of room to grow its business. That's because a growing company has no better use of its cash flow than plowing it back into expanding and enhancing its operations. For a fast-growing company such as Buffalo Wild Wings (Nasdaq: BWLD  ) , the statement of cash flows reveals that nearly all operating cash flow is being spent as capital expenditure for things such as building and opening new restaurants. In this instance, it has bright growth prospects and so would do shareholders a disservice by buying back stock. As an example, Dell (Nasdaq: DELL  ) was aggressively repurchasing its stock back in 2000 near $40 as the price fell dramatically, reaching a low of $20 by 2001.

Final considerations
To add another wrinkle, a company repurchasing its shares may not signal anything at all, and it usually doesn't. Share buybacks have become commonplace; just last week there were at least 15 repurchase announcements, including by Tiffany & Co. (NYSE: TIF  ) , Tim Hortons (NYSE: THI  ) , (Nasdaq: AMZN  ) , and Boeing (NYSE: BA  ) .

Just as certain investors may be accused of using the herd mentality, the same applies to companies. Right now, buybacks are widely employed, as they are looked upon favorably by shareholders in general, causing an occasional immediate pop in stock prices. That means some companies may repurchase stock just because every one else is, even if the shares have reached new highs or there are plenty of high-return opportunities remaining from operating activities.

There is a final perverse motivation sometimes used, to prop up a stock, although there are SEC rules to prevent this type of activity.

The Foolish bottom line
So how to do you find value stocks? By discounting expected future cash flows and demanding a significant margin of safety. And while that's a more complicated process than simply screening for share buybacks, the rewards can be incredible.

That's how Fool value guru Philip Durell finds value opportunities in his market-beating Inside Value investing service. If you'd like to see what he's recommending today, click here to grab a free 30-day guest pass.

Fool contributor Ryan Fuhrmann is long shares of Dell but has no financial interest in any other company mentioned. Buffalo Wild Wings is a Hidden Gems pick. Dell and Amazon are Stock Advisor selections. Dell is also an Inside Value pick. The Fool has an ironclad disclosure policy. Feel free to email Ryan with feedback or to further discuss any of the companies in the article.

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