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Why Share Buybacks Aren’t as Great as They Seem

Whenever a company has excess cash sitting around, there are five ways that management can use it: capital expenditures, acquisitions, paying down debt, increasing dividends, or share buybacks.

Capital expenditures and acquisitions may be a wise move at times, but are usually not popular with shareholders. Paying down debt can certainly make a company more secure, but with interest rates so low, reducing the debt load doesn’t come with very much reward. Increasing the dividend is always a popular move, but it’s a decision that’s very difficult to take back; investors are not forgiving towards companies that cut or suspend their dividends.

Share buybacks, on the other hand, can be especially appealing. Management teams love them because they don’t require the same level of ongoing commitment as dividends. Buybacks can also be a way to signal management’s confidence in the company. Shareholders love them, because they boost earnings per share, and almost always result in an increased stock price.

In fact many investors screen for stocks that have a history of buying back shares. But there is a downside.

Like any investment, buybacks are only wise when a company’s share price is depressed. The problem is that most companies don’t follow this pattern, and the reason is simple. When times are good, a company has more cash available for buybacks, but that is also when its share price is likely at lofty levels. Conversely, during the down times, a company is more likely to hoard cash, precisely when its shares are trading at a discount.

A perfect example comes from one of Canada’s oldest companies.

Canadian Pacific: A case study

Consider Canadian Pacific (TSX: CP)(NYSE: CP). Back in 2006 and 2007, when the company was doing well and the stock was flying high, CP repurchased 8.2 million shares at an average price of $63.03. Two years later, in February of 2009, the company was short of cash – the economic crisis and a recent acquisition were both taking their toll.

So CP was forced to issue 12.6 million new shares at $36.75 each. By doing so, the company raised the same amount of money (about $500 million) that it had spent earlier on its buybacks. But the end result was an extra 4.4 million shares outstanding.

Fast forward five years, and CP shares now trade above $160, thanks to numerous improvements from CEO Hunter Harrison. Yet last month, the company announced it would buy back up to 5 million shares. If the company had done this two years earlier, it would have cost less than half as much.

Foolish bottom line

Share buybacks remain extremely popular with shareholders, especially short-term oriented investors who like to see a bump in the stock price. But this isn’t always the wisest use of capital. So before jumping at whatever company is buying back shares, you might want to take a second look.

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Fool contributor Benjamin Sinclair holds no positions in any of the stocks mentioned in this article.

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