Sears Buybacks Mean Business

Sears Holdings' (Nasdaq: SHLD) most recent earnings report reveals that the company has been spending hundreds of millions of dollars -- all to buy back its own stock. That seemingly odd strategy can actually pay off big time … if it's done right.

The basics of buybacks
After taking in revenue and covering expenses, some companies still have money left over. They can use those funds to pay a dividend, pay down debt, invest in their business, or buy back shares, among many other possibilities. Among these strategies, share repurchases get little attention from investors. But they can be powerful wealth builders when executed effectively. 

When there are fewer shares of a company floating around in the market, the shares you own represent a bigger piece of its total share "pie." With fewer shares and shareholders clamoring for a piece of the company's earnings, you get more for each share you own.

Sears in gear
Sears provides a perfect example. At the end of its 2006 fiscal year, the company sported 155.7 million shares outstanding. At the end of its 2009 fiscal year, ended last month, it had just 114.9 million, a full 26% less.

The company bought back those missing 40 million shares, essentially retiring them. If you owned 10 million shares of Sears when it had 155.7 million shares, you'd own 6.4% of the company. If you still had your 10 million shares when there were only 114.9 million shares, you'd suddenly own 8.7% of the company.

In short, the retail giant has bought back enough shares to make a real difference in the value of its remaining stock. Better yet, management has noted that it's still authorized to buy back nearly $600 million more.

The dismay of dilution and destruction
Share buybacks aren't always as striking or productive as Sears' has been. Some companies buy back shares only to offset all the new shares they've been issuing as rewards to executives and other employees. This keeps existing stockholders from watching their shares' value get watered down, but it doesn't add any true worth.

Buying back shares at the wrong time can also prove unwise. If the company uses shareholders' money to repurchase shares at too-high prices, it's effectively destroying value. At those times, admirable companies will instead use the money in another, more effective way, whether by paying a dividend, buying a promising rival, or investing in business improvements.

In Sears' case, over the past year, the company bought back 7.1 million shares at an average price of around $60. The last time I checked, the shares were trading over $100 each. It looks like Sears spent its money sensibly.

Who's buying back?
To see how Sears stacks up to other buyback programs in the corporate world, I've rounded up a few examples. Bear in mind that while companies may be authorized to devote a certain amount of cash to buybacks, they don't always spend that full amount:

Source: Company releases. Based on prices as of March 5.
*Home Depot buyback amount includes remaining funds authorized for share repurchase. For other companies, amounts include only most recent authorizations and in some cases exclude outstanding but previously authorized buyback amounts.

If you don't keep track of a company's share repurchases, you might wind up with the wrong impression of its overall financial results. Successful buybacks could help mask falling revenue and earnings, which would otherwise stand out as a decline in earnings per share.

A company's statement of cash flows will help you see how much cash it's made from operations, financing (borrowing money or issuing stock), or investing (selling off factories or other assets). In general, the more money a company makes from operations, the better. Otherwise, be wary.

Like Sears, the best companies make their buybacks at the right times -- when shares trade below their true worth -- and for the right reasons. In such cases, shrewd and responsible buybacks can be a great sign that your investment dollars remain in savvy hands.