There's little point in a company buying back shares if they're overpriced, but it makes sense if they're cheap.

You'll have come across them in newspapers and in the pages of this publication, but are you left wondering what is meant by a 'share buyback'? And are you baffled because The Intelligent Investor sometimes heaps praise on the use of this capital management technique, but at other times pans it as destructive to shareholders' wealth? Accusations of schizophrenia aside, there is a valid explanation. But we'll get to that a little later, first, let's cover the basics.

When a company has surplus cash above and beyond its medium-term requirements, a decision to return that surplus 'capital' to shareholders is often made. Directors can do this by increasing the regular dividend, paying a special dividend or making a capital return. All three options shrink the company's bank balance and return money to every shareholder pro rata. But these aren’t the only options.

A buyback also returns capital to shareholders, but on a selective basis. Instead of giving money to every shareholder, the company uses its excess cash to buy back shares and then cancels them. Those shareholders who want cash can sell some or all of their shares, while those who don't sell end up owning a slightly larger percentage of the business—and therefore have a more valuable shareholding. That's the theory anyhow.

To read more of this article regarding buying back shares, visit The Intelligent Investor at www.intelligentinvestor.com.au for more information on "value investing" and buying shares.