WallStreetJournal. When a Stock Buyback Is Good for Investors

Stock buybacks are booming—but investors should be careful. While they are designed to return capital to shareholders, buybacks often don't pan out the way investors hope.

Warren Buffett made the biggest splash recently, when Berkshire Hathaway BRKB -0.95% announced it would step up its buyback program. But he isn't alone. Buybacks through the first three quarters of the year are about 50% greater than the average since 2000, according to Standard & Poor's. And because the looming "fiscal cliff" threatens to create a raft of tax hikes, even more companies might shift from dividends to share buybacks, which are more tax-efficient.

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Berkshire Hathaway CEO Warren Buffett

In theory, buybacks should be good for investment returns. When a company spends surplus cash buying back its stock on the open market, it reduces the overall share count. That gives every remaining investor a slightly bigger proportionate stake in the company. With a lower share count, earnings per share increase.

Many investors say they prefer a higher dividend to a buyback program. Dividends, after all, are simple, and visible. The money shows up in the brokerage account.

But buybacks have their advantages. Dividends are taxable—and the maximum rate next year may jump to 43.4% from 15%. Buybacks, on the other hand, trigger no taxable event among the investors who don't sell.

What's more, buybacks allow long-term investors to keep raising their effective stake without cost or effort, notes Michael Mauboussin, chief investment strategist at Legg Mason, LM -1.58% a Baltimore money manager with $650 billion under management. If the company raised the dividend instead, investors who wanted to reinvest in the company would have to buy new stock each quarter, likely with new brokerage fees each time.

Mr. Mauboussin argues investors should always prefer buybacks to dividends if they believe the stock to be undervalued, because a buyback cashes out other investors at the current (supposedly undervalued) price. If investors don't think the stock is undervalued, one might question why they own it at all.

One problem with buybacks is that, too often, companies overpay for the stock repurchased. That costs the remaining investors money.

Critics note that companies tend to buy back stock most aggressively when shares are most expensive. For example, in the third quarter of 2007, when share prices were near their peak, members of the S&P 500-stock index spent $171 billion on buybacks. In the first quarter of 2009, with the market near its low, they spent just $31 billion.

A second problem is that, in many cases, companies that buy back stock don't end up reducing their overall share count. That's because they are also issuing new stock, and options, to management and staff. Most buybacks "just mop up [stock] dilution," says Albert Meyer, a forensic accountant and owner of Bastiat Capital, an investment adviser in Plano, Texas, with $25 million under management.

Since Dec. 31, 1999, members of the S&P 500 have spent $3.5 trillion buying back their stock—or about a quarter of the value of those companies' equity at the start. Yet over that period, S&P estimates, their total share count has grown by about 7%. Stock grants to management aren't the sole reason, but experts say they have played a big role.

Mr. Buffett's program at Berkshire Hathaway is a model—and investors should look for other buyback programs that follow suit.

Mr. Buffett is disciplined on price. He will buy back company stock, he says, only if it is trading for 120% or less of the per-share net asset value, a level he deems a bargain for his remaining stockholders. Mr. Buffett estimates Berkshire's "intrinsic value" is far higher.

Nor does Berkshire lavish options and restricted stock upon top executives. "Buffett's buybacks truly shrink the share count," says Mr. Meyer.

And Berkshire is buying back stock with surplus capital, not with debt. Companies that borrow to buy back their stock, or to pay dividends, aren't returning capital—they are taking on risk.

The trick for investors is finding other such companies.

Investors worried a company might be offsetting its buyback program by issuing new shares should check each quarterly earnings statement filed with the Securities and Exchange Commission, available at www.sec.gov.

They should look for a line item called "average fully diluted share capital" or something similar. It usually appears at the bottom of the quarterly income statement. Investors can simply check to make sure that number is going down, not up, each quarter.

As for debt: The balance sheet in the same quarterly filing will show whether the company's net borrowings are rising or falling.

On price, Mr. Mauboussin says the best measure of a buyback is to compare the price paid with the per-share earnings. If, say, Amalgamated Widgets trades at $100, and it is expected to earn $7 per share annually, then buying back stock at this price will effectively earn a 7% return.

Remaining investors benefit only if the return from a buyback is better than what the company can earn elsewhere.

With interest rates so low at the moment, buybacks are a tempting way for companies to try to earn returns better than they could get from cash. There is no hard number, but companies that can earn 5% or more on their buybacks might be spending the money wisely.

Such legwork is one reason many investors prefer the simplicity of dividends. But those who can spot a good buyback deal should pounce.