Share buybacks are all the rage. In 2004 companies announced plans to repurchase $230 billion in stock—more than double the volume of the previous year. During the first three months of this year, buyback announcements exceeded $50 billion.¹ And with large global corporations holding $1.6 trillion in cash, all signs indicate that buybacks and other forms of payouts will accelerate.²

In general, markets have applauded such moves, making buybacks an alluring substitute if improvements in operational performance are elusive. Yet while the increases in earnings per share that many buybacks deliver help managers hit EPS-based compensation targets, boosting EPS in this way doesn't signify an increase in underlying performance or value. Moreover, a company's fixation on buybacks might come at the cost of investments in its long-term health.

A closer inspection of the market's response to buybacks illustrates these risks, since some companies' share...