The concept behind a share buyback seems simple: Reducing the number of shares outstanding increases earnings per share, and multiplying the higher EPS by the price-earnings ratio raises the share price. But investors generally know less about the mechanics of buybacks, why companies engage in them, how much they increase EPS and the effect they have on several metrics used by analysts.

Management has many possible reasons for buying back shares, including:

- It believes the market has significantly undervalued the stock; that is, the shares are cheap.

- It wants to return shareholder value without committing to a long-term dividend payment. Buybacks are a more flexible option.

- It wants to avoid diluting share value by issuing new company stock for option exercises. Most investors believe this is a good reason for buybacks.

- It wants to improve financial metrics of the company - return on assets, return on equity and most directly EPS.

It's easy to understand the first three reasons. As for the fourth, although a stock buyback increases the firm's leverage as measured by the ratio of debt to equity, this isn't a typical reason for buying back stock.

EPS improvement is a striking reason for a stock buyback. The unfortunate focus of the media and Wall Street on quarterly results drives markets in the short term, but if a repurchase keeps the shares out of the market over the long term, the rewards can be powerful.

Professional analysts widely believe that executives can exercise a lot of discretion in how they report company performance, according to a recent survey by PricewaterhouseCoopers. Share repurchases are one tool available to management.

Timing of Share Buybacks

Understanding the calculation of EPS is crucial to understanding share buybacks. EPS is simply the amount of net income available for distribution to holders of common stock divided by the average number of shares outstanding. For our purposes we'll discuss diluted EPS, the more conservative and most widely used value for EPS. This measure includes other equity items that could convert into common shares, such as employee stock options, warrants and convertible debt, in the number of shares outstanding.

A weighted average is used to calculate the number of shares outstanding. As a result, transactions happening earlier in the year that reduce shares outstanding have a bigger impact on results than those occurring later in the year.

Consider this simplified example in calculating the number of share days. A company with 1 million shares outstanding bought back 100,000 shares on March 31, 2007. This means 1 million shares were outstanding for 90 days (for 90 million share days) and 900,000 were outstanding for 275 days (for 247.5 million share days). The weighted average shares outstanding would be calculated by dividing the total number of share days by the number of days in the year, so the company reduced the number of shares in the EPS calculation from 1 million to 924,658 (see table).

By conducting the buyback on March 31, management eliminated the dilutive effects of the new options on the current year's EPS with a lower cash outlay than it would have spent by doing this on the day of the option award.

Advanced Share Repurchases

As an alternative to typical buyback programs, investment banks offer advanced share repurchases. These provide an opportunity for investment banks to take advantage of any short-term decreases in the stock price of a company buying back shares.

The arrangement allows management to reduce the number of share days, thereby accelerating a buyback's impact on the EPS calculation. Most advanced share repurchases occur in the first fiscal quarter so that the company can obtain the greatest possible reduction in share days and last only until the end of the current fiscal quarter.

In this agreement, the company and bank first approve to a minimum price the company will pay for the shares at the end of the quarter; most likely this is the price on the date the deal closes and the company receives the shares. The investment bank then short sells a number of shares to the company that the company normally would have repurchased over the designated period. If the share price increases over the period, the company pays the difference. If the stock price drops, the bank earns a profit from the short sale.

The company sees an immediate reduction in shares outstanding and in the number of share days used in the EPS calculation, regardless of the stock price. Since the repurchase of shares doesn't affect the income statement, the company's only concern is keeping the buyback's total amount within the limits authorized by the board.

Let's say that in 2007, management planned to buy back 100,000 shares by repurchasing 33,333 shares on the first day of each month in the first quarter. Then an investment bank offered a plan for acquiring all 100,000 shares on Jan. 2.

We'll now compare the two alternatives, using the assumptions for initial shares outstanding, net income and P/E from the previous example (see table). To have a baseline, we'll first look at what happened if there was no buyback. The weighted average number of shares remained unchanged, so with a net income of $5 million and P/E of 15, the share price was $75.

Moving to the management plan of buying 33,333 shares at the beginning of each month, the result was a drop in the number of share days to 908,311. This improved EPS by $.50 and led to a share price of $82.50.

An advanced share repurchase, however, added $.05 to the EPS value simply because of the timing. Management did this without risk to the income statement. Although the company wouldn't have known the exact price of the repurchased shares until the program was completed at the end of the first quarter, there appear to be few pitfalls in this arrangement - as long as the company's cash needs are met during the quarter and management hasn't reduced equity below restrictions in debt covenants or regulations.

Evaluating Buybacks

Investors should ask three questions regarding buybacks:

- Did the buyback improve EPS or mask issues with organic and acquisition growth? You can find the number of shares repurchased during the year, along with how management views the program, in the management discussion and analysis section of the company's 10-K. Earnings announcements frequently discuss organic growth and the contribution of new acquisitions. But without specific information from management, you'll have difficulty discovering how much of a change in EPS is attributable to organic growth, acquisitions and share repurchases. Investors often compare segment results to determine organic and acquisition growth, but how do they find EPS growth from share repurchase plans?

- Did management use the cash wisely to return value to the shareholders? A share repurchase should increase EPS, but that doesn't mean it was the best investment of cash by management. In Berkshire Hathaway's 1984 annual report, Warren Buffett says: "When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no other alternative can benefit shareholders as surely as repurchases." A repurchase makes sense only when there are no other alternatives for the cash in the business.

- Did management keep the repurchased shares, or did it return them to the market? This may be a litmus test for some, but if the outstanding shares rise significantly after the repurchase, you need to understand why. Know whether shares were used only to cover stock option exercises or to fund future liquidity needs.

Share repurchase programs are a powerful tool to return value to shareholders. But they also help companies in managing EPS and other financial metrics. Investors need to understand management's intentions for the share repurchase and ask it to specify the goals.

Mark Eckman

This article has been republished with permission from BetterInvesting. BetterInvesting is a leading nonprofit investment education association with members consisting of individual investors and investment clubs. Founded in 1951, BetterInvesting is considered the voice of the individual investor. BetterInvesting is dedicated to providing a sound program of investment education and information to help its members become successful long-term, lifetime investors. Get more information about BetterInvesting. BetterInvesting 100 Index (NASDAQ: $BIXX).

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