The chart may look like multicolored spaghetti but it tells a very interesting story. It’s a five-year look at the equity of railroad corporation CSX. Look at the blue line representing the earnings per share. They have risen nicely, but focus now on the red line (shares outstanding) and the blue line. The rise in earnings is coming from reductions in the number of shares. Earnings per share is calculated by dividing the net income by the number of shares outstanding, so if you reduce the number of shares, then earnings will increase even though net income in dollars may not change ($2000/50=$40 but $2000/30=$66).
Normally, if the number of shares which represent the equity in the company declined and net income was the same or larger, the return on equity (ROE) would increase. Notice, however, that in CSX’s case the ROE (orange line) was declining for most of the five-year period. That would be a warning for an investor that the basic business was not improving, even though the increasing earnings would indicate otherwise.
The final line to focus on is the green line representing the amount of debt being issued each year. Now it might be coincidental that after two years of reducing debt the company turned on a dime and started to issue a billion dollars a year in debt, but as an old mentor of mine said, ‘coincidence is a clue’. In this case, the clue would be that maybe all that debt was not being used to improve the business position of the company, but was being used to purchase stock.
While buying stock back is all the rage now, it can fool an investor into thinking they own a company whose basic business is improving. As this discussion has demonstrated, this company has reduced its equity by using cash flow and debt to purchase stock. This is essentially taking money from one pocket and putting it in another: there is no net gain in business value; however, the risk of owning the stock has increased because the company has more debt.
Buying back stock is okay as long as the company doesn’t borrow to do it. If a company wants to buy stock, it should be a capital allocation decision to spend money on stock instead of on something else. Raising your ROE without improving the business is a phony way to do things and will end badly.
Don't be fooled by a company's high ROE, rather look behind the numbers and see how they are achieving it. Only then will you be able to assess the company's methods and motives for buying back stock.