3 ways to solve the share buyback riddle

When a company announces a stock buyback, take a closer look at what’s behind the decision. Other than the usual rhetoric of returning the company’s wealth to shareholders, there are many less altruistic reasons like improving balance sheet ratios or fending off corporate takeovers.

Management is not likely to fess up to the real motives behind a repurchase. With a little research, investors can read between the lines and come to their own educated conclusions.

Here’s how.

• EPS and PE ratios: When shares are repurchased, key metrics like earnings per share (EPS) and the price earnings (PE) ratio look better because the share count falls. Whether the intention is to meet analysts’ estimates and prop up the stock price, or for management to meet its EPS-based compensation targets, keep a safe distance from these activities.
• Excessive debt: Be wary of companies who take on excessive debt to buy back shares (or to pay dividends). These companies aren’t returning capital; instead, they’re taking on risk, and will ultimately hold future capital hostage to interest and principal payments. Take a look at the balance sheet to see if net borrowings are rising in the face of repurchases.
• Reason for repurchase: A majority of companies simply repurchase shares to counteract the effects of warrants and options, and are willing to buy them at any cost to the detriment of shareholders. Make sure the net change in shares is diminishing over time, not simply that shares are being repurchased.