Why Share Buybacks Aren’t as Great as They Seem

Buybacks are very popular with investors. But too often they’re done at the wrong time.

| More on:
The Motley Fool

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.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

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

More on Investing

Businessman holding tablet and showing a growing virtual hologram of statistics, graph and chart with arrow up on dark background. Stock market. Business growth, planning and strategy concept
Investing

3 Roaring Stocks to Hold for the Next 20 Years

Given their long-term growth potential, these three outperforming stocks could continue their uptrends.

Read more »

stock data
Stocks for Beginners

1 Stock to Steer Clear of

TFI stock (TSX:TFII) has seen shares drop by 18% after earnings, but unfortunately it doesn't look like the first quarter…

Read more »

edit Sale sign, value, discount
Investing

Have $500? 3 Absurdly Cheap Stocks Long-Term Investors Should Buy Right Now

Given their healthy long-term growth prospects and cheaper valuations, these three TSX stocks could deliver superior returns in the long…

Read more »

A bull outlined against a field
Stocks for Beginners

2 Top Bargain Stocks Ready for a Bull Run

These two top Canadian stocks look undervalued right now but might not remain cheap for very long.

Read more »

A close up image of Canadian $20 Dollar bills
Dividend Stocks

2 TSX Dividend Stocks With Yields Above 7% That You Can Buy With $100

Here are two high-yielding TSX dividend stocks you can buy with less than $100 per share today and hold for…

Read more »

oil and gas pipeline
Dividend Stocks

Should You Buy Enbridge Stock on a Pullback?

Down 25% from all-time highs, Enbridge stock remains a top investment choice due to its diversified business and steady cash…

Read more »

A airplane sits on a runway.
Coronavirus

3 Things to Know About Air Canada Stock Before You Buy

Air Canada stock continues to hover below $20 despite the sharp rise in travel demand seen across the industry. What's…

Read more »

Money growing in soil , Business success concept.
Investing

2 TSX Stocks That Doubled Investors’ Money Within 5 Years

Analysts think these two stocks are fairly valued.

Read more »