Friday, September 22, 2017

Share Buybacks and Dividends Are Not The Same Thing

Share buybacks have gained prominence in the past twenty years. The amount corporations spend on buybacks exceeds the amount they spend on dividends. Plenty of investors mistakenly believe that dividends and share buybacks are equivalent.

They are not.

I prefer dividend payments. When a company declares and pays a cash dividend, this is yours to keep. You can do anything with that cash. The dividend represents a return on investment, and an instant cash rebate on your original purchase back. Every shareholders receives the same treatment per each share they own. Plenty of investors these days hate dividends, because of their tax inefficiency. When you earn dividend income, and you are in the high tax brackets, you can pay over 20% to the government. These investors forget that most stock in the US is now held in retirement accounts, where taxes are either deferred for decades or they are tax-exempt. So the easy solution for most investors in the US is to buy stock in retirement accounts.

When a company declares a buyback, not all shareholders are impacted the same way (this example of course assumes that the company indeed follows through with the buyback, which is not always the case). When a company declares and executes a buyback, and you do not sell, you won’t have to pay a dime in taxes. Plenty of people love this idea, and focus on the tax efficiency aspect above everything else. However, the investors who sold their shares back to the company have to pay taxes on any gains, assuming they held the shares in a taxable account. By the way, if an index fund holds the stock, it needs to sell a portion of the shares, because the float is reduced from the share buyback.

In theory, since the number of shares is reduced, your stake is now worth more. In reality, companies can end up wasting that money if they overpay for their shares. Companies typically find themselves with too much cash on hand when things are go very well, trading that cash for overvalued shares. If the business keeps growing, the share price will likely increase, and shareholders will be happy that the share buyback was a great deal. For example, if Coca-Cola (KO) bought back stock in the 1980s at a split adjust $3 - $4/share, the remaining shareholders would have been better off.

However, if the share price doesn’t grow or it falls, shareholders would have been better off with a dividend. For example, Eastman Kodak had done billions in share buybacks over the years. Shareholders who stuck with their investment in the Rochester Photo Company ended up with nothing. They would have been better off if they were receiving more in cash dividends than in share buybacks.

As I mentioned above, I prefer dividends to share buybacks.

This is because if a company pays a dividend, every shareholder is treated the same way. Plus, each shareholder has the option to reinvest the dividend back into the company or reinvest those dollars elsewhere ( or even spend it). If the business fails, you at least received some cash from it. If the business succeeds, you received a higher stock price and a lot of cash to be allocated to its best use at the time of receipt. Perhaps you could have been better off if the company reinvested the dollars for you through a buyback, but unfortunately, the end result will not be known in advance (and it is tough to predict).

If a company declares a share buyback, different shareholders are treated differently. The decision to reinvest or not has been done to you. If the stock price goes up from here, the decision to buyback would seem as a smart one in retrospect. If the stock price goes down, and/or the business fails, the shareholder would have been left with nothing. Again, the end result is not known in advance unfortunately. Predictions are tough, particularly the ones about the future.

I am not giving dividends enough fair credit with the comparison above however.  Under 99.99% of situations I am aware of, when companies declare a dividend, they end up fulfilling their promise and distributing the actual payment at the same time to all shareholders. It is much easier to predict the level of annual dividend payments than the levels of share prices. This is what makes living off dividends such a potent strategy for retirees. However, when a company announces a share buyback, there is no guarantee that it would indeed start it or complete it. Furthermore, the timing of the share buyback is more sporadic versus a cash dividend. For example, as we discussed in a previous article, companies have limitations about the timing of those share buybacks, in order to avoid being charged with manipulating their share prices. Therefore, even if dividends and share buybacks for a given company are of equivalent amount, they would have different effects on shareholder wealth.

I will illustrate my preference for dividends over share buybacks with an actual example.

Bed Bath and Beyond (BBBY) spent billions between 2011 and 2016 to repurchase roughly 100 million shares at prices that were roughly two to four times the price today. The share price went up initially, and then stayed up, right when the company was repurchasing shares at a high price.

Unfortunately, the share price has gone down after the company bought back over 100 million shares, as threats from online competitors over traditional brick and mortar stores have pushed valuations lower. It seems like remaining shareholders would have been better off receiving a dividend, rather than keeping a larger share of an enterprise that is smaller and has a smaller earnings power. The only investors who were better off were those who were selling out of their stock. I wonder how many of the remaining shareholders were patting themselves on the back that BBBY was distributing cash in the form of tax-efficient buybacks or tax inefficient dividends. They ended up not paying taxes on dividend income they would have otherwise received. They would have been better off receiving what they see as a tax inefficient cash distribution, rather than receiving a tax efficient share buyback.

Unfortunately, the company started paying a dividend just last year for the first time. This is a good real life example showcasing that dividends and share buybacks are not the same thing. After looking at the chart, it is obvious that shareholders in Bed Bath and Beyond would have been better off receiving a dividend all those years, rather than a share buyback.

I often see those situations where a company has too much excess cash at hand. Rather than distribute dividends, they decide to reduce the number of shares outstanding. The problem is that when companies are successful, their valuations tend to be high. After a period of slowing growth, the valuations go down. As a result, companies end up paying high valuations with buybacks, and are left with stock selling for lower valuations. In the case of Bed Bath and Beyond, the stock was selling for roughly 15 times earnings in 2015. Today, the stock is selling at roughly 5 times forward earnings. Ironically, the stock today is really cheap, assuming that earnings per share are at least maintained. When valuations are depressed, this is the best time to repurchase stock. Unfortunately, most companies tend to repurchase stock when they are flush with cash and share prices are high, and they stop share buybacks when prices are low. This is the opposite strategy for how a successful share buyback should work.

Plenty of investors today let the tax tail to wag the investing dog with their preference for buybacks over dividends. Astute investors should focus on the best possible outcome no matter what happens, and not exhibit a narrow focus on a single item such as taxes.

Given the fact that I am risk averse, I prefer dividends over buybacks. I want the companies I invest in to grow earnings, dividends and share values for the next 5 decades. However, I know that real life is bumpier than the linear projections from an excel forecasting model. I prefer that excess cashflow that is not needed in the business be distributed to me as dividends. I prefer the surer return of a dividend and potential for a capital gain over the uncertain outcome of boom or bust that a share buyback offers.

Relevant Articles:

Dividends Unlock Value For Shareholders
This is why you shouldn't overpay for stocks folks
Dividends versus Homemade Dividends
Does Paying a Dividend Reduce a Company’s Value?
Dividends versus Share Buybacks/Stock repurchases

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