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The continued expansion of corporate stock buybacks in the S&P 500 is one of the biggest stories in the stock market over the past couple of years.

U.S. companies have bought back nearly $1 trillion in stock over the past 10 quarters, by far the largest buyback boom in history.

Somewhat lost in the media coverage, however, is a key thought: Is this a good thing for shareholders?

Companies can return excess cash to shareholders in two ways: by paying dividends or by buying back stock. Recently, companies have been favoring buybacks … by huge amounts. S&P 500 index members repurchased $117.7 billion in stock in the first quarter of 2007, up 17.5% from year-ago levels and 275% from the first quarter of 2001. Dividends, meanwhile, were up just 9.52% and 72.39% over the same time frame.

What’s telling about those numbers is that they came AFTER the implementation of the dividend tax cut, which improved the tax treatment of dividends to place them on-par with capital gains.

Why the discrepancy? Is it because buybacks preserve corporate flexibility and allow shareholders to defer taxation on their gains? Maybe.

But it can’t hurt that buybacks funnel directly into executive compensation. Often, year-end executive bonuses are tied to stock prices … so by boosting the share price, executives get a bit of extra cash at Christmas. More importantly, buybacks boost the value of unvested options, leading to outsize paybacks down the road. Dividends, meanwhile, are just money out the door.

Buffett and others have criticized the practice. Shareholders have even sued companies for engaging in buybacks while insiders sold shares (see Sprint Nextel, for example). Nonetheless, I can’t help but feel that the issue gets short-shrift in the media, which treats buybacks as fully shareholder friendly actions. It is, as always, more complicated than that.

Source: Are Share Buybacks Actually Good For Investors?