A corporation can do several things with its earnings.  We’re interested in companies that distribute those earnings to shareholders in the form of dividends but earnings can also be used in an attempt to grow the company to maintain or increase market share and, through that, increase future earnings.

One of the non-dividend and non-growth uses of earnings that’s of particular interest to shareholders is the share buyback.  With a share buyback a corporation reduces the number of shares it has outstanding by buying them from existing shareholders.  This has the effect of making each share outstanding represent a tiny fraction more equity in the business than it did before the buyback.

But, although stock buybacks can serve to increase shareholder value over the long term as each share is now worth more and entitled to a slightly higher dividend distribution it has zero effect during the year the buybacks occurred.  That’s because the capital that was used for the share buybacks could have been used to increase dividends instead.  That would have essentially created the same value for existing shareholders as the now slightly higher share price has after the buyback.

Longer term shareholders benefit from a buyback much more than existing shareholders but, overall, share buybacks are not the tremendous benefit to shareholders that corporations typically hold them out to be.

So, excluding potential public relations benefits, why do corporations buy back shares?

A typical reason is the need to distribute an unusually large quarter of earnings in a way that won’t substantially affect the long term expectations of market watchers or shareholders. A measured and steady growth in dividends is just what dividend investors are looking for and seemingly out of the blue increases, while no doubt welcome, inject an increased expectation of similar payouts in the future and negative publicity if they end up not happening with enough regularity.

Instead of issuing quarterly dividends per share of $0.23, $0.25, $1.15, and then $0.25 and fielding calls from worried shareholders wondering “what happened?” in the fourth quarter when that $1.15 third quarter payment was the result of a one-time unexpected influx of revenue (from the sale of a business unit perhaps), corporations decide to use those funds to buy back shares instead.

It’s the same net effect, serves to reward long term shareholders, and keeps company balance sheets free from the appearance of volatility where none actually exists.  Like many topics in dividend investing, your perception of the value of share buybacks depends on your own personal opinions.  There are investors that love share buybacks and those that hate them but, in the end, the don’t have tremendous shareholder impact either way.