Stock buybacks have a great reputation for being a powerful way for shareholders to build wealth, and they've been especially popular lately.

According to a December 2007 Standard & Poor's report, stock buybacks have become one of the largest expenditures that S&P 500 companies make. In the past three years, companies have bought back around $1.32 trillion in shares, beating out capital expenditures ($1.28 trillion), regular dividends ($600 billion), and research and development ($375 billion). In the third quarter of 2007, buyback levels had increased 57% year over year.

So what exactly is a share buyback? Well, when a company makes a hefty profit, it can spend that money on growing the business, paying down its debt, rewarding employees, or rewarding shareholders through a dividend payment. It can also buy some of its existing shares on the open market and then essentially retire them: the share buyback.

The good side
Why are buybacks good for investors? Let's look at the math via a simplified example.

Imagine that Scruffy's Chicken Shack (Ticker: BUKBUK) has 100 shares outstanding, and you own five of them, or 5% of the company. (This is really simplified. Black & Decker (NYSE: BDK), for example, recently had more than 60 million shares outstanding; 100 shares is approximately one 600,000th of the company.)

If Scruffy's bought back 10 shares, 90 would remain. Assuming you still held your five shares, they would now represent 5.6% of the company. Your ownership stake has gone up, and each share is tied to a bigger piece of the company.

Think of the firm's earnings per share (EPS), for example. If its net income for the year was $600, pre-buyback the EPS would be $6. After the buyback, the net income would be divided by 90 shares, yielding an EPS of $6.67.

Buybacks thus increase the earning power of your investment by increasing the amount of the company each share represents.

Over the past few years, plenty of well-known blue chips have executed sizable stock buybacks.


Buybacks from 2004 Q4 to 2007 Q3

Goldman Sachs (NYSE: GS)

$21.7 billion

ExxonMobil (NYSE: XOM)

$76.2 billion

Microsoft (Nasdaq: MSFT)

$57.4 billion

Time Warner (NYSE: TWX)

$21.5 billion

Procter & Gamble (NYSE: PG)

$29.4 billion

Cisco Systems (Nasdaq: CSCO)

$26.2 billion

Source: Standard & Poor's.

But wait!
Although stock buybacks seems like an unqualified benefit, there's the potential for downside. If the shares are bought back when they're trading at inflated prices, then the company isn't doing its shareholders any favors. In fact, it's destroying value.

Sometimes buybacks are executed simply because it will look good, conveying management's confidence in the company, when there are actually better uses of the funds.

But more importantly, the conventional wisdom about the worth of share buybacks may not hold water. A recent S&P study noted that many believe that stock prices rise from buybacks, that more buybacks have a bigger impact than fewer buybacks, and that buybacks reduce total shares outstanding. Yet S&P's Equity Research Services actually looked at the data from the beginning of 2006 to the middle of 2007 and concluded that none of those three points was supported by the actual figures. Yikes!

What to do
Since buybacks may not be so effective, what should you do? Well, investigate how promising one is before getting excited about it. And also...

Consider dividends instead! As my colleague James Early has pointed out in his article "Make Millions with 7 Stocks," the vast majority of gains from stocks over the past 130 years have come from reinvested dividends. Furthermore, high-yielding dividend-paying stocks often have higher earnings growth than their lower-income counterparts.

Why do dividends seem like a more reliable path to wealth than buybacks? Well, remember that buybacks are executed by managements that are often trying to look good to the public. Dividends reflect more of a long-term commitment. No company wants to ever lower or eliminate its dividend, so it isn't likely to overpay them. Companies know that raising dividends regularly is attractive to investors, so they try to do that, too.

For help finding significant dividend payers, I invite you to check out our Motley Fool Income Investor newsletter, which recommends two compelling investments each month. Last time I checked, its recommendations were beating the market with average returns of 21%, vs. 14%, and there were more than 20 recommendations with dividend yields topping 6%. A free trial will give you access to all past issues and all recommendations -- it's worth a look.

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