Why Stock Buybacks Are a Waste of Shareholder Resources

So far in 2010, U.S. companies have announced $273 billion worth of stock buybacks -- more than five times as they had at this time last year, according to The Washington Post. But evidence suggests that such buybacks may not be the best use of corporate resources: Boards should replace CEOs who can't devise better ways to allocate shareholder resources.

The logic behind stock buybacks is hollow: By reducing the number of shares outstanding, the company increases its earnings per share, which should in theory boost its stock price. But since this move does nothing to boost the cash flow of the company, it may signal to investors that the company is out of productive uses for its capital and should just pay it out in the form of dividends.

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Research can be found to support those on both sides of the stock buyback debate. USA Today reported that roughly 66% of stock buybacks in 2000 through 2009 lost money for shareholders, according to Michael Gumport of research firm MG Holdings. Gumport analyzed 280 companies during the period -- finding that Dell (DELL) was among the worst performers -- losing $17 billion on stock buybacks. But I lean towards Gumport's view.

David Ikenberry, finance professor at the University of Illinois, came to a more favorable conclusion. He argues that between 1984 and 2009, companies that did buybacks "outperformed benchmarks by more than 12 percentage points during the four years after buybacks," according to USA Today.

Buybacks: A Bonus-Boosting Scheme?

Companies that do stock buybacks defend them as a way to maintain the number of shares outstanding for employees. But are CEOs just pushing these buybacks because the boost in EPS will justify bigger bonuses? Consider these recent examples of companies that have bought back stock:

• Hewlett-Packard (HPQ), said on Aug. 31 that it would spend $10 billion buying its shares. Since then its shares have risen 5.7%. EPS growth was one of three indicators -- also including sales and total shareholder return -- on which former CEO Mark Hurd got his $30 million in 2009 compensation, according to HP's 2010 Proxy.

• Pepsico (PEP) announced on March 15 that it would buy back as much as $15 billion in common stock over the next three years. Since then its shares have risen 3%. EPS growth is one of four indicators -- the others being growth in revenue, operating profit, and cash flow -- on which CEO Indra Nooyi received her $15.8 million in 2009 compensation, according to Pepsico's 2010 Proxy.

• Microsoft (MSFT) trumpeted a $40 billion stock buyback on Sept. 22, 2008. Since then, its shares have lost 6% of their value. EPS growth is not among the indicators -- which include meeting revenue, profit, market share and product launch targets -- on which CEO Steve Ballmer got his $1.3 million compensation for 2009 according to Microsoft's 2010 Proxy.

• IBM (IBM) approved an $8 billion stock buyback on April 27. IBM stock has since risen 7%. EPS is one of four indicators -- the others being revenue growth, net income, and cash flow -- on which CEO Sam Palmisano got his $24 million in compensation for 2009, according to IBM's 2010 Proxy.

These results suggest that it would be a mistake to assume that there is a clear correlation between announcing stock buybacks and how a company's stock performs. Many factors can drive changes in stock price up or down following a buyback announcement, such as acquisitions -- IBM and HP have done many -- actual earnings and guidance compared to expectations, and changes in management.

But I think it is more than a coincidence that all but Microsoft base their CEO compensation, in part, on EPS growth -- a measure that stock buybacks clearly boost.

In theory, a CEO can use corporate capital to make an acquisition, develop a new product, build new plants, hire top talent, or expand into a new country. Given how much CEOs get paid, if the best idea one can come up with for investing his company's resources is buying back its stock, then the board of that company should find a new CEO who can come up with a better strategy.