Corporate buybacks are a simple financial maneuver to boost the earnings per share (EPS) of a company. They used to be illegal and I now see why.
Here is what happens. Cash is used to buy back shares. To get EPS, net income is divided by the diluted number of shares outstanding. The smaller number of shares outstanding (the denominator), the bigger EPS is.
The problem is that most companies do not assess the proper price to buy back their own stock. In other words, someone in the financial arm of the company has so much money to put into buybacks within a certain time frame. Therefore, they buy their shares no matter if the share price is overvalued or undervalued. If the share price is overvalued, they pay too much per share just like an investor may do.
Unaware investors buy the stock for the “Robust” EPS growth. They think because the EPS is climbing significantly that the company is growing much more quickly than it actual is in a true operational sense. Without really "looking under the hood" at the company's financial statements and understanding why EPS is growing so quickly, the investor can be fooled.
Basically, many investors are duped by the financial maneuver of share buybacks which are a "slight of hand". Add significantly increasing the Debt/Equity of the firm with cheap debt and the CEO can look like Albert Einstein to the uninformed.
In extreme cases, return on equity seems to grow to the sky because equity is shrinking smaller and smaller. Eventually shareholders equity turns into a negative value even with companies that have robust operating earnings. This means ROE suddenly goes from extremely high numbers like 400% (a general proxy is 10 to 20%) to a large negative number. What?!
Thus I ask, have stock buybacks gone too far?
Be smart, be well-read, be aware and be successful.
