Beware of Stock Buybacks

This article originally appeared Jan. 27, 2014, on Real Money. To read more content like this, + see inside Jim Cramer's multi-million dollar portfolio for FREE -- Click Here NOW.

There are few to no truisms when it comes to stock market investing. Some statements sound like they could be true on all occasions, but that is never the case. Not all stocks trading at low price-to-earnings ratio (P/E) multiples are undervalued. Not all dividend paying stocks are safer than non-dividend payers, and not all blue-chip stocks are necessarily safer investments than smaller companies. You can keep going and going. Any time you hear an absolute investment statement, you should immediately be skeptical.

Another statement that many think is always a good is share repurchases. Guess what? Not all share repurchases are good either. But a lot of CEOs try to hide behind  them as good shareholder value creation tools. The purpose of a share buybacks is certainly a noble one; when done correctly, they do add enormous value for shareholders.

First, when a company repurchases its stock, this reduces shares outstanding and thus gives existing equity holders more ownership of that company. If you own 10,000 shares in a company with 1 million shares outstanding, you own 1% of that business. If the share count declines to 900,000 due to buybacks, your 10,000 share block now equals nearly 1.2% of that company.

Second, fewer shares outstanding means profits are divided over a smaller number. This makes earnings per share (EPS) increase. Since Wall Street loves EPS growth, many company's look at share buybacks as a way to keep analysts happy.

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