Bad Buyback, Bad!

"Don't just stand there, do something!"

Those words are spoken all too often by impatient investors who, in the fast-paced world of investing, demand the quickest, cleanest, no-nonsense ways for management to get a company's share price moving.

Invest in building the company? Nah, takes too long. Issue or raise dividends? Well, investors will get stuck with a tax bill. Save money for a rainy day? Please, activist shareholders will have the CEO booted out in no time.

Today companies often choose to reward shareholders with a simple and popular method investors love: share buybacks.

Less share = more despair?
The math behind buybacks is simple: By buying back their own shares, companies reduce the number of shares the corporate pie is divided into, leaving existing shareholders with a larger slice of everything from net assets to earnings per share. On top of this, fewer shares available for trading reduces supply on the open market and might help give share prices a boost. Sounds simple enough.

It is, and buybacks can be rewarding when done responsibly, but those three words all too often elude management, especially when management's view of the future is clear skies ahead.

When a company buys back its shares, it moves capital from one part of the balance sheet to another. Just as Newton reminded us, "For every action, there's an equal and opposite reaction," every share bought back by a company comes with a corresponding drop in cash on the balance sheet.

When times are good and cash is flowing, using excess greenbacks to purchase shares seems reasonable, but when the fun stops and the money gets thin, that same company may be forced to issue shares en masse to regain the needed liquidity.

In short, too many companies buy high and sell low.

D'oh!
Consider struggling bond insurer Ambac (NYSE: ABK). Last February, Ambac decided to issue $400 million in debt to fund a share buyback program when its stock hovered around $90. Fast-forward 12 months, and Ambac is faced with huge losses stemming from subprime-backed debt and is now scrambling to raise funds. One option to raise the needed to cash would be to issue shares -- except today's share price sits nearly 90% lower than it did when millions of shares were bought back just months ago.

How would you feel if you bought a house and, less than a year later, were forced to sell that house for 90% less than you paid for it, to raise cash just to keep your head above water? Welcome to Ambac's world.

And the fun doesn't stop there. Not only were shares purchased at multiple times their current level, but investors are still on the hook for the debt Ambac took out to fund the buybacks. Checkmate.

Ambac isn't the only company to strike out with share repurchases. Take a look at the companies that spent vast sums buying back shares in 2006 only to see share prices flounder.

Keep in mind that when a company buys back its own stock, it's investing in its own company. Just as individual investors need to pay close attention to the price they pay before deciding to invest, companies that pay lofty levels for repurchases may end up paying dearly.

Look a little closer ...
Why else might a company decide to take part in a buyback? Sometimes it isn't an attempt at returning money to shareholders. Sometimes it's a way to clean up the damage done by issuing stock options given to employees and management.

For example, say a company announces a plan to buy back 1 million shares of stock. If that same company issues 1 million shares from exercised stock options, shareholders won't feel the buyback's full effects.

So, are all buybacks bad, then? Of course not. When companies have excess cash, and their share prices undergo a beating that will likely be temporary, they can be a great, tax-free way to reward shareholders.

In the crash of 1987, studies showed that part of what propped the market up in the ensuing days was companies swooping in to repurchase their own battered shares -- to investors' delight.

The cash used to repurchase shares belongs to you, the shareholder. Next time you see headlines touting a big buyback, ask yourself, "Am I happy with management investing my cash at these prices?" If not, take a closer look and make sure management isn't squandering your hard-earned money.

For related Foolishness:

• The Skinny on Share Buybacks
• The Dark Side of Stock Buybacks
• Shrink! Buybacks of 10 Undervalued Stocks.