The Motley Fool: Stock buybacks can be better than dividends

Companies frequently announce that they’re buying back some of their shares. According to Merrill Lynch, U.S. companies announced 1,503 stock buyback programs totaling a record $703 billion in 2006, up 50 percent over 2005.

Here’s how they work: When a company buys back stock, it typically does so on the open market — it doesn’t buy your shares, unless you happen to be selling them. You keep your shares.

With the company out there buying shares, the stock price may pop a bit, due to an increased demand for the shares. Generally, the more shares a company buys and retires, the better off you, the shareholder, are. Imagine that Gas Prices Inc. (ticker: ARMLEG) is divided into 100 shares. If you own 25 of them, you own 25 percent of the company. If the company buys back 50 of its own shares, then there will only be 50 shares. You’ll still own your 25 shares, though, so you now own 50 percent of the company.

That’s extreme, but it demonstrates how your share of a company’s earnings grows as more shares are bought back. If Gas Prices earned $100 in net income, that would be $1 EPS (earnings per share), pre-buyback. After the buyback, though, the firm would still have the same earnings, but those earnings would be spread over just 50 shares — so the EPS would go up to $2. The price-to-earnings (P/E) ratio, based partly on EPS, would fall, and each share potentially would be worth more.

Stock buybacks can be better for shareholders than dividends. Remember that companies pay taxes on the income they earn. When they then pay out any dividends to you, you get taxed. So that income is taxed twice — hardly very efficient. By buying back shares, a company is still rewarding shareholders, by making existing shares more valuable, but it’s doing so in a way that does not trigger taxable events for shareholders.

Just make sure your companies’ earnings aren’t increasing solely because they’re buying boatloads of shares. Look for increasing sales or revenues, too.

Ask the Fool

Q: How bad a problem is the level of CEO pay, and what can be done about it? — Y.M., Sacramento, Calif.

A: With companies such as Pfizer and Home Depot recently giving outgoing CEOs sayonara packages worth many millions of dollars, the issue of extravagant CEO compensation is again in the news.

Congress is paying attention. Sen. James Webb, D-Va., noted during his rebuttal to the president’s State of the Union address: “When I graduated from college, the average corporate CEO made 20 times what the average worker did; today, it’s nearly 400 times.”

The problem is that CEOs typically give themselves hefty raises and get rubber-stamped by their boards of directors (who are often CEOs themselves). One possible remedy is Rep. Barney Frank’s, D-Mass., proposal to require public companies to have shareholders vote on executive compensation plans.

Still, given corporate America’s strong ties to Washington, it will be a tough sell. Consider contacting your representatives to express your views. Learn more at www.coopamerica.org/ socialinvesting/ shareholderaction, www.corporatepolicy.org/ issues/comp.htm and www.thecorporatelibrary.com. And remember that some CEOs who earn millions are worth it, if they’re generating gobs of value for their companies.

My Smartest Investment

In mid-2002, I read a positive Motley Fool article about a stock called Sportsman’s Guide. I had $9,000 in cash in my brokerage account and spent it all on the company’s stock. I recently got a notice that the company was being bought by another firm for $31 per share, giving me nearly $49,000. That’s an increase of almost $40,000 on $9,000 in just four years — not bad! — H. Alexander, Long Beach, Miss.

The Fool Responds: Thanks for letting us know of your success. Not all our recommendations skyrocket, but we do our best to deliver superior ideas. You’ll find lots of educational articles as well as some stock recommendations at www.fool.com, and you might want to try our Motley Fool Stock Advisor newsletter, too. (You can do so for free at www.fooladvisor.com.) Over the past five years, its picks have, on average, more than doubled the market’s return, gaining 72 percent vs. 31 percent. Sportsman’s Guide, by the way, was snapped up by Redcats USA, which is owned by PPR, owner of Gucci and Yves Saint Laurent.