As investors, we're conditioned to believe that the announcement of share buybacks is good news for a company. After all, such an announcement represents management's confidence in the fact that the share price is undervalued, and nobody knows the business better than management. For some shareholder groups, buybacks offer a tax advantage that dividends do not. While these arguments are almost always completely accepted by shareholders, the investor must consider the fact that management and shareholder interests do not always align (as discussed here), resulting in a great deal of cases where buybacks actually destroy shareholder value rather than create it.
Consider a company which pays its management in stock options (indeed it is rare not to find such a company today). If management were to pay a dividend, shareholders would receive cash, but the value of management's options would drop. (For an explanation of this phenomenon, see this discussion.) On the other hand, when a company buys back and cancels its own shares, each share ends up owning a proportionately larger amount of the company, which can result in an increase in the value of an option. Management may have no malicious intent, yet it is nevertheless impossible for their actions to be completely detached from their personal well-being.
Stock options aside, managements are in their positions because of their abilities in running the operations of the business. They are not experts at capital allocation, nor are they good predictors in the field of macroeconomics. Yet when they buy back shares, they are implying that they can allocate capital better than shareholders. Rather than give the cash to the shareholder, at which point the shareholder can decide what's best for himself, management has made this decision for him.
As an example, here is a look at the dividends and buybacks of the last four quarters for some of America's most prominent retailers. The dividends are small, but the buybacks are enormous. Unfortunately, investors would have been much better off with the cash in their hands. The chart shows what the dividend yield would have been had the money used for buybacks been paid out. It also shows the average price at which companies bought back shares, and compares it to their current price:
Each of these companies save for Wal-Mart (NYSE: WMT) paid significant premiums over the stock price. In the case of Home Depot (NYSE: HD), had they paid out the cash used in their buybacks, the dividend yield would have represented a staggering 30% of the current stock price. Certainly, this dividend represented a one-time outlay and is not sustainable, but it would have represented a shareholder-friendly action from a company looking to regain shareholder confidence after a difficult few years.
All of the companies listed above save for Wal-Mart wasted great opportunities to put funds in the pockets of their shareholders. Rather than try to value the shares of their employers, or predict where the economy is going, management should focus on its operations and direct its free cash flow into the hands of shareholders.
Disclosure: The author has a long position in BBY and HD