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A Bigger Slice of the Profits

When companies buy back their shares, the plan is to carve up earnings into larger pieces. But do buybacks always work?

What do ExxonMobil, Goldman Sachs, Harley-Davidson and IBM have in common? Each has a healthy appetite for its own stock. In fact, all of corporate America seems to be feasting. In 2005, U.S. companies announced a record $458 billion of stock buybacks on the open market. The banquet is still going strong in 2006, with 108 buybacks worth $66 billion announced so far. By buying their own stock with spare cash, companies are signaling that the shares are a good value at the current price. The large volume of buybacks hints that the broad market is undervalued. And with fewer shares trading, remaining shareholders get a larger ownership stake -- a bigger slice of the earnings pie.

But the truth about buybacks is more complex. Despite record buybacks, the aggregate number of shares outstanding of companies in Standard & Poor's 500-stock index is rising, says UBS Securities, primarily because companies have been issuing so many stock options to executives and employees.

You can find the money spent on buybacks in a company's cash-flow statement. But the income statement is where a company's share count is compared from year to year. Between the two, you'd find, for example, that Yahoo spent nearly $1 billion to repurchase shares last year, while the number of shares outstanding rose 2%. ConocoPhillips spent $1.9 billion, but the number of shares increased 3%.

Still, 80 firms have decreased their share count by at least 4%, including Exxon, Goldman, Harley and IBM. If you own stock in a firm that really does reduce its share total, the buyback can pay off. A portfolio equally weighted with companies that have positive earnings trends and share-count reductions of 2% or more, rebalanced quarterly, would have returned nearly 20% annually since 1984, compared with 13% for the SP 500, says Lehman Brothers.


Still, you need to be clear on the rationale behind a buyback. Has a temporary cloud put the stock in the bargain bin? Then a buyback -- especially if executives are buying for their own accounts -- is bullish. Similarly, in a maturing industry or slowing economy, buybacks are a legitimate way to boost the return -- more promising, for example, than using the cash for doubtful expansions. Altria is the poster stock here. Since 1989, the former Philip Morris has trimmed its share count by 2% annually and increased earnings per share more than 10%.

Expect buybacks in general to remain popular this year. The motivation won't so much be issuing stock options; companies are actually issuing fewer of them due to restrictive accounting rules. Rather, more companies will use repurchased shares as a war chest for acquisitions. And more seem committed to simply serving up a bigger slice of the pie. Yum.