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 downright bad idea and can hurt shareholders. This can happen when buybacks are done in the following circumstances:

For starters, buybacks should only be pursued when management is very confident the shares are undervalued. After all, companies are no different than regular investors. If a company is buying up shares for $15 each when they are only worth $1 0. the company is clearly making a poor investment decision. A company buying overvalued stock is destroying shareholder value and would be better off paying that cash out as a dividend. so that shareholders can invest it more effectively. (Find out what dividends can do for your portfolio in The Power Of Dividend Growth .)

2. To Boost Earnings Per Share

Buybacks can boost EPS. When a company goes into the market to buy up its own stock, its decreases the outstanding share count. This means that earnings are distributed among fewer shares, raising earnings per share. As a result, many investors applaud share buybacks because they see increasing EPS as a surefire approach to raising share value.

But don’t be fooled. Contrary to popular wisdom (and, in many cases, the wisdom of company boards), increasing EPS doesn’t increase fundamental value. Companies have to spend cash to purchase the shares; investors, in turn, adjust their valuations to reflect the reductions in both cash and shares. The result, sooner or later, is a canceling out of any earnings-per-share impact. In other words, lower cash earnings divided between fewer shares will produce no net change to earnings per share.

Of course, plenty of excitement gets generated by the announcement of a major buyback as the prospect of even short-lived EPS can gives share prices a pop-up. But unless the buyback is wise, the only gains go to those investors who sell their shares on the news. There is little, if any, benefit for long-term shareholders. (For more insight, see How To Evaluate The Quality Of EPS .)

3. To Benefit Executives

Many executives get the bulk of their compensation in the form of stock options. As a result, buybacks can serve a goal: as stock options are exercised, buyback programs absorb the excess stock and offset the dilution of existing share values and any potential reduction in earnings per share.

By mopping up extra stock and keeping EPS up, buybacks are a convenient way for executives to maximize their own wealth. It’s a way for them to maintain the value of the shares and share options. Some executives may even be tempted to pursue share buybacks to boost the share price in the short term and then sell their shares. What’s more, the big bonuses that CEOs get are often linked to share price gains and increased earnings per share, so they have an incentive to pursue buybacks even when there are better ways to spend the cash or when the shares are overvalued. (Learn more in the Pages From The Bad CEO Playbook .)

4. Buybacks That Use Borrowed Money

For executives, the temptation to use debt to finance earnings-boosting share purchases can be hard to resist, too. The company might believe that the cash flow it uses to pay off debt will continue to grow, bringing shareholder funds back into line with borrowings in due course. If they’re right, they’ll look smart. If they’re wrong, investors will get hurt. Managers, moreover, have a tendency to assume that their companies’ shares are undervalued — regardless of the price. When done with borrowing, share buybacks can hurt credit ratings. since they drain cash reserves that can serve as a cushion if times get tough.

One of the reasons given for taking on increased debt to fund a share buyback is that it is more efficient because interest on debt is tax deductible, unlike dividends. However, debt has to be repaid at some time. Remember, what gets a company into financial difficulties is not lack of profits, but lack of cash.

5. To Fend Off an Acquirer

In some cases, a leveraged buyback can be used as a means to fend off a hostile bidder. The company takes on significant additional debt to repurchase stocks through a buyback program. Such leveraged buybacks can be successful in thwarting hostile bids by both raising the share value (hopefully) and adding a great deal of unwanted debt to the company’s balance sheet.

6. There Is Nowhere Else to Put the Money

It’s very hard to imagine a scenario where buybacks are a good idea, except if the buybacks are undertaken when the company feels its share price is far too low. But, then again, if the company is correct and its shares are undervalued, they will probably recover anyway. So, companies that buy back shares are, in effect, admitting that they cannot invest their spare cash flow effectively.

Even the most generous buyback program is worth little for shareholders if it is done in the midst of poor financial performance, a difficult business environment or a decline in the company’s profitability. By giving EPS a temporary lift, share buybacks can soften the blow, but they can’t reverse things when a company is in trouble. (Learn more in Cash-22: Is It Bad To Have Too Much Of A Good Thing? )

Conclusions