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."
Stock buybacks are one of several ways that a company can try to return cash to shareholders, although other ways - chiefly a dividend increase - are much better for shareholders.
In a stock buyback, the company uses some of its cash reserves, or possibly borrows money, to purchase shares of its own stock. The net effect is to reduce the number of shares outstanding. With fewer shares, the earnings per share rises, theoretically adding value to all remaining shares.
Say Company X has earnings of $1.00 per share and 100,000 shares outstanding. If Company X than repurchases 50,000 shares of its own stock, the EPS will double to $2.00 per share.
Note, however, that the amount of profit the company has actually earned hasn't increased. That's the dangerous illusion of stock buybacks. They can create a mirage of growing profits.
Now, in many cases the company is growing profits as well, but the stock buybacks make the growth appear far more dramatic - alluring bait to potential investors.
Take the case of DirecTV (Nasdaq: DTV), for instance. The satellite TV provider has sliced the number of its shares outstanding in half over the past five years.
Without the share buyback, DTV's earnings would have risen an impressive 88% to $2.58. But with the share buybacks, DirecTV's earnings nearly quadrupled to $5.22.
Other stocks that have more than tripled over the past five years include The Gap Inc. (NYSE: GPS), Kohl's Corp. (NYSE: KSS), and Norfolk Southern Corp. (NYSE: NSC).
But at least those companies also have growing businesses. Other companies that have embarked on large share buyback programs over the past few years would have had flat or even negative earnings, according to Fortuna.
That group includes such companies as Lockheed Martin Corp. (NYSE: LMT), Cintas Corp. (Nasdaq: CTAS), Wellpoint Inc. (NYSE: WLP), and Dun & Bradstreet Corp. (NYSE: DNB).
Despite their limited utility and deceptive nature, stock buybacks figure to remain a popular option in 2014 and beyond.
For one thing, stock buybacks are a quick and easy way to appease activist investors, who have become increasingly aggressive in recent years.
Stock buybacks also can become addictive. Once your shareholders get accustomed to the EPS increases that share buybacks deliver, it's not so easy to stop.
And as long as the U.S. Federal Reserve keeps interest rates near zero, the cost of borrowing money for share repurchases will remain attractive to corporate boards.
Companies in the S&P 500 have already designated $1 trillion more for stock buybacks over the next few years.
As stock buybacks become more and more of a corporate crutch, investors will need to make sure they know where a company's earnings are really coming from before they buy.
"It's become almost a panacea for a lot of companies that are having trouble otherwise improving their earnings," Fortuna's Milano told Bloomberg News. "They're taking out shares to make up for poor earnings and that just isn't really washing with investors."
What's your take on stock buybacks? Are most companies better off investing in their business operations, or raising their dividends? Let us know on Twitter @moneymorning or Facebook.
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