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Why Share Buybacks Are Hit And Miss For Investors

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Legal & General’s (LSE: LGEN) CEO, Nigel Wilson, this week hit out at companies that undertake share buybacks. Indeed, he said that the process of a company using excess cash to buy back and subsequently cancel its own shares adds little economic value, and instead capital should be invested in intellectual and physical assets so as to provide a boost to the economy.

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Clearly, he makes a sound argument. The process of buying shares does not improve the profitability of a company as a whole and does nothing to improve the economy. So, why do it?

Improved Per Share Figures

Most investors (and company boards) are concerned with per share figures, whether that’s earnings per share (EPS), dividends per share or any other measure on a per share basis. Although share buybacks do not increase profits, they do increase them on a per share basis and, it is believed, this could help provide a boost to the company’s share price. Furthermore, share buybacks also help to counter the dilutive effects of share options, which left unchecked would increase the number of shares in existence and dilute per share measures.

Long-Term Problems

However, as mentioned, share buybacks use cash that could often be put to better use elsewhere. That could be in the form of the company investing in research & development, buying new plant or training/hiring new employees — all of which could improve profitability in the long run. Furthermore, a dividend may be a more efficient allocation of capital, with shareholders investing it in other companies that could help to boost investment elsewhere.

Hit Versus Miss

Of course, share buybacks are best viewed on a case by case basis. In other words, for some companies they can be a great idea, while for others they can prove to be anything but. Much of this depends on growth opportunities within the company and, more importantly, on whether the shares are good value at the time of the buyback.

For example, Reed Elsevier (LSE: REL) and Compass (LSE: CPG) have recently undertaken share buyback schemes. In the case of Reed Elsevier, this amounted to £350 million over the course of this year, while Compass has had three buybacks in the last two years, with the latest amounting to £500 million. However, in both of these cases, shares in Reed Elsevier and Compass appear to be unattractive at current levels (they currently trade on P/Es of 16.6 and 20.8 respectively), so it doesn’t seem to make much sense for a company to buy them.

Indeed, they’d be better waiting for their shares to offer better value. For instance, BskyB (LSE: BSY) announced a £750 million share buyback last year and, despite rising around 15% over the last year, now trades on a P/E of 15.8. Still not hugely cheap, but better value than many companies that engage in share buybacks.

The Solution?

A possible solution is to pay a dividend and have a share buyback programme — but only if the shares represent good value for money. That’s what Next (LSE: NXT) has decided to do, with the company focusing on the equivalent rate of return from buying back shares versus investing the cash elsewhere. Once shares reach a certain price level, the return falls and makes investing elsewhere more attractive. Therefore, Next only buys back its shares when they offer good value and a better relative return. Judging by the performance of its share price over the last five years (it’s up 340%), this seems to be a sensible solution.

Of course, the great irony is that Legal & General (where the CEO is against share buybacks) seems to offer great value at current levels, with a P/E of just 13.6, which makes them highly suitable for a share buyback!

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Peter does not own any of the above shares. The Motley Fool has recommended BSkyB.

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