Imagine a successful company like Apple. It generates enormous amounts of free cash flow, far more than it needs to run its business and invest in future growth. It uses this excess profit to buy back its own shares. This reduces the number of shares outstanding, which increases Earnings Per Share (EPS) and the ownership stake of the remaining shareholders. In this scenario, shareholder equity remains robust and positive because it is constantly being replenished by massive retained earnings.
Now, consider a company with stagnant growth, inconsistent profits, or a struggling business model. To make its financial ratios look better and to prop up its stock price, the management might decide to buy back shares. But where does the money come from if not from excess profits? It often comes from taking on new debt or draining cash reserves that are needed for operations and innovation.
This is the “bad” buyback. The company isn’t creating new value; it’s using leverage to manipulate its financial appearance. On the balance sheet (Assets = Liabilities + Equity), liabilities (debt) go up, and assets (cash) go down to pay for the shares. This combination aggressively eats away at the equity portion of the equation. When a company buys back so many shares that the cost exceeds its retained earnings and initial capital, shareholder equity flips to negative. It means the company’s liabilities now exceed its assets, a state of technical insolvency.
Even more concerning, is when a company does both buybacks and dilutions (selling new shares). This is a major red flag. It’s like a frantic attempt to tread water: they sell new shares to raise needed cash (diluting your ownership), and then use cash (often borrowed) to buy back other shares to support the stock price. This financial churn suggests a lack of a coherent long-term strategy, prioritizing short-term stock performance over fundamental business health.
