Stock Buyback

6 Bad Stock Buyback Scenarios

Buying back shares can be a sensible way for companies to use extra cash. But in many cases, it's just a ploy to boost earnings and, even worse, a signal that the company has run out of good ideas. This means that investors can't afford to take buybacks at face value. Find out how to examine whether a buyback represents a strategic move by a company or a desperate one.

When Buybacks Work

A share buyback happens when a company purchases and retires some of its outstanding shares. This can be a great thing for shareholders because after the share buyback, they will own a bigger portion of the company, and therefore a bigger portion of its cash flow and earnings.

In theory, management will pursue share buybacks because they offer the greatest potential return for shareholders - a better return than it could get from expanding operations into new markets, investing in the brand or any of the other uses that the company has for cash. If a company with the potential to use cash to pursue operational expansion chooses instead to buy back its stock, then it could be a sign that the shares are undervalued. The signal is even stronger if top managers are buying up stock for themselves. (To learn more, read How Buybacks Warp The Price-To-Book Ratio.)

Most importantly, share buybacks can be a fairly low-risk approach for companies to use extra cash. Re-investing cash into, say, R&D or new a new product can be very risky. If these Investments don't pay off, that hard-earned cash goes down the drain. Using cash to pay for acquisitions can be perilous, too. Mergers hardly ever live up to expectations. Share buybacks, on the other hand, let companies invest in themselves when they are confident their shares are undervalued and offer a good return for shareholders. (For more, see how you can Use Breakup Value To Find Undervalued Companies.)

When Buybacks Fail

Some of the time, share buybacks can be a great thing. But oftentimes, they can be a...