Stock buybacks have their advantages. In many cases, their tax treatment is more favourable to investors than are dividends. Furthermore, buybacks are not expected to be as regular as dividends, and therefore they offer more flexibility to companies (i.e. when a company has business opportunities, it can invest, and when it doesn't, it can pay out).
But as investors, we are conditioned to believe that the announcement of share buybacks is good news for a company, the prevailing wisdom being that such an announcement represents management's confidence in the fact that the share price is undervalued.
While these arguments are almost always completely accepted by shareholders, the investor must consider the fact that management and shareholder interests do not always align (as discussed here), resulting in a great deal of cases where buybacks actually destroy shareholder value rather than create it.
Consider a company which pays its management in stock options (indeed it is rare not to find such a company today). If management were to pay a dividend, shareholders would receive cash, but the value of management's options would drop. (For an explanation of this phenomenon, see this discussion.) On the other hand, when a company buys back and cancels its own shares, each share ends up owning a proportionately larger amount of the company, which can result in an increase in the value of an option. Managements may have no malicious intent, yet it is nevertheless impossible for their actions to be completely detached from their personal well-being.
Stock options aside, managements are in their positions because of their abilities in running the operations of the business. They are not experts at capital allocation, nor are they good predictors in the field of macroeconomics. Yet when they buy back shares at certain times but don't at others, they are implying that they can allocate capital better than shareholders. Rather than give the cash to the shareholder, at which point the shareholder can decide what's best for himself, management has made this decision for him.
As an example, here is a look at the dividends and buybacks of the four quarters ending mid-2008 for some of America's most prominent retailers. The dividends are small, but the buybacks are enormous. Unfortunately, investors would have been much better off with the cash in their hands. The chart shows what the dividend yield would have been had the money used for buybacks been paid out. It also shows the average price at which companies bought back shares, and compares it to their current prices:
Each of these companies save for Wal-Mart (NYSE: WMT) paid significant premiums over the current stock price. In the case of Home Depot (NYSE: [[HD]]), had it paid out the cash used in its buyback, the dividend yield would have represented a staggering 27% of the current stock price. Certainly, this dividend represented a one-time outlay and is not sustainable, but it would have represented a shareholder-friendly action from a company looking to regain shareholder confidence after a difficult few years.
But this chart only shows the premium these companies paid over their current stock prices. During the stock market lows of late 2008 and early 2009, their prices dropped even lower. Nevertheless, most of these companies did not buy back a single share in the first half of this year, with Walmart being the exception once again.
This process of buying high and not-buying low has cost shareholders dearly. This shows all too clearly that managements are not proficient capital allocators and are no better at timing the market than anybody else, despite their inside knowledge. As such, managements should focus on operations, and direct free cash flow (i.e. cash earned above what is required for capital expenditures) into the hands of shareholders as it is earned, rather than trying to time the market.