Get Rich with Dividends: A Proven System for Earning Double-Digit Returns

Buybacks versus Dividends

Rather than pay a dividend, one favorite management use of excess cash is a stock buyback—or at least the announcement of a stock buyback.

A typical buyback announcement will sound something like this:

Company X said Thursday it plans to repurchase up to $100 million or two million shares of its common stock as part of its stock repurchase authorization through December 31, 2013.

What this means is that management, at its discretion, can go into the market at any time and buy its own shares. Doing so reduces the share count and increases the earnings per share (EPS).

For example, see Table 4.1. A company that earns $20 million per year and has 20 million shares outstanding will earn $1 per share ($20 million divided by 20 million shares). If it buys back 2 million shares of stock, the $20 million in earnings is now divided by 18 million shares, which equals $1.11 per share.

Table 4.1 Stock Buybacks Can Increase EPS

Let’s assume the stock trades at a price/earnings (P/E) ratio of 15. In the first scenario, it would trade at $15 (15 P/E × $1 EPS). In the second, if it maintained the 15 P/E after a buyback, it would trade at $16.65 (15 P/E × $1.11 EPS).

But here’s why management teams love the share buyback program: Not only can it increase EPS, but the executives are in complete control of the funds.

So if the economy turns south or there is a hiccup in the ...