We were asked, "How can you tell if a company's increased earnings per share isn't just due to the company buying back shares of its stock?"

That's a great question. While share buybacks are generally good, as they boost the value of each remaining share of stock, ideally they shouldn't be the only driver of earnings per share (EPS) growth. Also, if a company's stock is trading at too-high levels, then the company is squandering money by buying back shares at inflated levels. Share buybacks should occur at attractive levels.

But back to the question. To see what's going on, focus on net income. Share buybacks reduce the number of shares outstanding (because shares bought back are essentially retired). When the number of shares decreases, the earnings per share rise. To get a handle on what's happening without regard to buybacks, just examine the total net income, before it's divided by the number of shares and becomes EPS. Then compare that number with EPS.

For example, look at these numbers for AutoZone (NYSE:AZO), for 2004 and 2005 (dollar amounts are in millions):

2005 2004 Change (2004-2005)
Net earnings $571 $566.2 1%
Diluted EPS $7.18 $6.56 9%
Shares outstanding $79 $86 (8%)

If you didn't know how many shares outstanding the company had, you could still tell that the number of shares had decreased, since EPS was increasing faster than net income (9% vs. 1%).

Richard Gibbons delved deeper into this topic last year, noting that:

"In the last reported quarter, Applied Materials (NASDAQ:AMAT) spent $500 million, Merrill Lynch (NYSE:MER) spent a billion, Bank of America (NYSE:BAC) spent $1.8 billion, and Citigroup (NYSE:C) spent $2 billion. These are some huge numbers, and shareholders are generally delighted to hear of such buybacks. But there are actually times when buybacks are terrible for shareholders.

"A good example of a bad buyback was IBM's (NYSE:IBM) share repurchases in the late 1990s. IBM, like most tech stocks of the time, was overvalued. Five years later, it still hasn't returned to the level at which it traded back then. Yet IBM was buying back shares. Even worse, if you look at the balance sheets for those years, you'll see that IBM's long-term debt increased. So, effectively, IBM was borrowing billions of dollars to repurchase its own overvalued shares. As a shareholder, this really isn't something you want your management team to be doing."

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