Buyer Beware: How Stock Buybacks Create False Value

Corporate stock buybacks are usually touted as good for investors – it's typically one of the top demands that activist investors make when targeting a company.

But while stock buybacks can benefit current shareholders, they tend to distort a company's earnings picture – which can mislead potential investors.

What's more, stock buybacks often are a poor use of cash compared to capital expenditures and research and development – investing in the business. And that type of spending has waned.

Stock buybacks aren't necessarily a bad idea – it often makes sense if a company has a lot of excess cash – but in the past few years, more and more companies have used them to boost their earnings per share (EPS) numbers.

A study by Fortuna Advisers showed that over the past five years, 216 of the companies in the S&P 500 got more of an increase in their EPS from share buybacks than from growing their businesses.

Last year, companies in the Standard & Poor's 500 spent $500 billion on stock buybacks – the most since the record of $589 billion in 2007 – and those companies have spent a staggering $1.7 trillion since 2008.

That's one reason the stock markets have soared despite a weak U.S. economy.

Stock buybacks have magically transformed what would have been an 80% increase in the S&P 500 from the 2009 lows to 178% increase.

"It's game playing – a legitimate, legal form of manufacturing earnings growth," Gregory Milano, the Fortuna Chief Executive Officer, told the Associated Press. "A lot of people [focus on] earnings per share growth, but they don't adequately distinguish the quality of the earnings."

Stock buybacks can mask other problems a company may be having, which also explains their rising popularity. But because the situation varies from company to company, it's up to investors to figure out what's really going on.

"How much credit should a company get earning from share buybacks rather than organic growth?" Brian Rauscher, chief portfolio strategist at Robert W. Baird & Co, told the Associated Press. "I think the quality of earnings has been much lower than what the headlines suggest."