Stock buybacks sure seem like a good thing. They reduce a company's share count, granting each remaining share a bigger stake in the company. Suppose, for simplicity's sake, that you own one share of a company with 10 shares outstanding -- a 10% stake. If that company buys back two of its shares, leaving eight shares (including yours) outstanding, your stake in the company just jumped from one-tenth to one-eighth.

But for all the benefits of buybacks, they can carry hefty disadvantages, too.

The dark side
Depending on a stock's value, buybacks don't always make sense -- sometimes, they're not going to yield the biggest bang for a company's buck. If a company with cash to burn on buybacks wanted to reward its shareholders, it could just as easily pay out that moola as a dividend. Or it could pay down debt. Or it could buy another company. Or it could spend the money on more advertising, more stores, more... you get the idea. There are choices.

Think of an overvalued company you know. Many investors think that (NASDAQ:AMZN) has gotten ahead of itself, with a share price recently topping $70 and a trailing P/E ratio far greater than 100. If the company spends $7 billion to buy back some of its stock, it will reduce its share count by 100 million shares. If the price were $35 per share, it would be able to buy 200 million shares. The price doesn't matter as much as the value, though. If you wouldn't buy Amazon at its current lofty prices, would you want the company spending your (shareholder) money on the same investment? Wouldn't you prefer that it spend the money on something with a potentially bigger return?

Buybacks make sense when the stock being bought is undervalued. When the shares purchased are overvalued, the company is essentially destroying shareholder value. There are usually more effective ways to deliver value to shareholders.

Some examples
Tom Jacobs recently tackled this topic at, quoting the CFO of Luminent Mortgage Capital (NYSE:LUM): "[W]e want to make sure that we are repurchasing stock at levels when the return on equity from doing that is competitive and hopefully meaningfully higher than the return on equities that we can obtain from other investments that we are looking at." Good point.

Jacobs adds: "Bad reasons are if buybacks are used to reduce or mask the effect of share count increases from options grants, to show 'confidence in our company' alone, etc. These are PR and spin motives that should make you reach for your wallet or purse."

After some number-crunching to determine the merits of certain buybacks, Jacobs concludes that firms making good buybacks include Luminent and Assurant (NYSE:AIZ). Meanwhile, "bad buybacks have come for a long time from Genentech (NYSE:DNA), NVR (NYSE:NVR), UnitedHealth Group (NYSE:UNH), and others, to name a few."

What to do
The next time you hear that a company you own (or want to own) is buying back its shares, check to see how much of a bargain those shares are.

As Jacobs mentioned, buybacks are often driven by a company's need to offset the increase in its share count caused by stock option grants. This is more common among younger, more rapidly growing companies. To avoid such scenarios, concentrate your stock-hunting among bigger, more established companies. Doing so will often give you the benefit of significant dividends, too.

We'd love to point you to some terrific companies via our Motley Fool Income Investor newsletter, spearheaded by James Early. Check it out free for 30 days! The last time I checked, it sported more than 30 recommendations with dividend yields topping 5%, and eight with yields above 7%. It was also outperforming the S&P 500 by six percentage points. You can get a taste of James' thinking in this article.

Longtime Fool contributor Selena Maranjian owns shares of She has recently heard that it's physically impossible for pigs to look up into the sky -- and she thinks that's sad. For more about Selena, view her bio and her profile. UnitedHealth is a Motley Fool Inside Value recommendation. Amazon and UnitedHealth are Stock Advisor recommendations. Try any one of our investing services free for 30 days. The Motley Fool is Fools writing for Fools.