Share buybacks have become hugely popular in recent years. By buying back their own shares and then cancelling them, companies can engineer an increase in earnings per share in excess of any increase in total profit.
In theory, the resulting increase in both earnings and earnings growth will support a higher share price and a higher price-to-earnings (P/E) rating.
If carried out correctly, share buybacks can represent an attractive investment opportunity for a business and its shareholders. But as I’ll explain, this is not always the case. Other motivations may drive some executives’ buyback decisions.
The sums of money committed to buybacks are often large and can exceed the cost of a company’s annual dividend. This means shareholders are swapping potential cash special dividends for the less certain benefits of a shrinking share count.
I think it’s worth considering more closely what buybacks mean for shareholders and how we can gauge whether they are likely to represent an attractive use of a company’s capital.
Dividend vs buybacks
A dividend is a cash payment that you or I will receive in our brokerage account. This payout reduces the book value of the company in line with the amount of...
