Dividends and buybacks split investors. Both are a form of cash return to shareholders, but both also have their drawbacks. Company executives view these two methods of cash return very differently and are often unsure which is the best strategy to adopt.
Three ways to return cash
When it comes to capital returns, a company should retain its earnings if it can earn a rate of return that is above the cost of capital. But if shareholders can earn a higher rate of return on capital than the company can, the firm should disburse the cash.
There are three ways a company can transfer cash to its shareholders:
- The company can sell itself for cash. Rewards all shareholders.
- A company can pay a dividend. Rewards all shareholders.
- A company can buy back its shares. Only shareholders who sell can cash in.
The topic of how best to return cash to investors through dividends and buybacks is especially relevant in today’s environment as corporate cash levels reach record levels.
However, the case for, and against buybacks and dividends is complex. Some investors swear by dividends, and others want buybacks only. Few have carefully and rigorously thought through their positions.
Credit Suisse’s Michael J. Mauboussin tried to answer some of the fundamental questions sounding buybacks and dividends in a research note issued to clients of the investment bank back in 2014. The following summary is a summary of Mauboussin’s research.
Question 1: How are share buybacks and dividends the same?
Buybacks and dividends are fundamentally the same; they’re both methods of distributing cash to shareholders. What’s more, assuming that taxation is identical, there are no transaction costs, dividend funds are reinvested at the same rate, and the stock is trading at a fair price, then there’s no clear, identifiable difference between buybacks and dividends.
However, in the real world, these assumptions do not hold. Therefore, from the point of view of the shareholder, buybacks offer more flexibility than dividends because they allow the shareholder to control the timing of taxes.
Question 2: How are share buybacks and dividends different?
The data shows that the most fundamental difference between buybacks and dividends is the attitude of executives. Specifically, executives tend to believe that maintaining the dividend is on par with investment decisions such as capital spending while buybacks are linked more to residual cash flow. As a result, dividends provide a strong signal about management’s commitment to distribute cash to shareholders and its confidence in the future earnings of the business. Buybacks tend to be viewed as a lever that can increase earnings per share under the right conditions.
As noted above, another key difference between buybacks and dividends is the fact that dividends treat all investors the same. Buybacks only benefit those that sell.
Question 3: What are the philosophies that motivate share buybacks?
The simple answer is there are three main philosophies that motivate buybacks, fair value, intrinsic value, and accounting. The first two philosophies help to create shareholder value while the third is a side effect of performance-based pay packets.
The first philosophy, fair value takes a steady and consistent approach to buybacks. Management recognizes that buying back stock is not an exact science and doesn’t try to time purchases. However, management also acknowledges that by distributing funds it’s less likely to do something foolish with the funds. Research suggests that most companies would have been better off buying back stock consistently versus their actual behavior of buying heavily in some periods and lightly, or not at all, in others.
The second philosophy, intrinsic value is based on the notion that a company should only buy back shares when it believes that they are undervalued.
And the third opinion is usually based on management’s desire to increase company EPS. This means that the goals of the program may not be aligned with shareholders. Increasing EPS may help management reach a financial objective that prompts a bonus.
Question 4: Share buybacks add to earnings per share, isn’t that good?
It’s important to note that buybacks do not necessarily increase EPS. The company has to pay for the buyback, which means that earnings are lower with a buyback program than they would be without it. As Mauboussin explains:
“A company can fund a buyback one of two ways. Either it can use excess cash, or it can borrow money. Whether a buyback is accretive or dilutive to EPS is a function of the relationship between the after-tax interest rate (either foregone from cash or incurred from debt) and the inverse of the price/earnings (P/E) multiple.”
Take the following example:
(click to enlarge)
Question 5: How should you assess the merit of a buyback program?
The golden rule of buybacks is that a company should only repurchase its shares when its stock is trading below its expected value, and no better investment opportunities have been identified.
Unfortunately, it’s difficult for shareholders to assess accurately the merits of a buyback program without access to additional (inside) information on the company’s operations and investment opportunities.
Question 6: Aren’t companies that overpay for their stock harming their shareholders?
“Only if a stock trades exactly at intrinsic value do buybacks and dividends treat all shareholders the same. If a stock is over- or undervalued, the effect of a buyback is different for selling shareholders than it is for those who continue to hold. “
Since management’s key focus should be on building value per share for continuing shareholders, it should always try to buy back shares that are undervalued. Therefore, buying overvalued stock does indeed harm shareholders. That said, assuming you own shares of companies that you think are undervalued buybacks will, by definition, increase value per share.
Question 7: Does it ever make sense to repatriate cash, pay taxes, and then buy back shares?
There’s a surprisingly simple answer to this question: Only if the stock price’s discount to intrinsic value exceeds the incremental tax rate of the repatriated funds.
The matrix below provides a guide to the analysis required for this calculation assuming an 8% cost of equity.
Question 8: Isn’t it true that the majority of total shareholder returns are the result of dividends?
No. According to Mauboussin, this is one of the great misconceptions of the investing industry as price appreciation is the only source of investment return that increases accumulated capital over time.
The key to understanding this comment is to distinguish between the equity rate of return and the capital accumulation rate. The capital accumulation rate, often measured as total shareholder return (TSR), is a multi-period measure that assumes all dividends are reinvested in the stock. The equity rate of return is a one-period measure that merely adds price appreciation to dividend yield.
The value of the compounding reinvested dividends means that the TSR, or capital accumulation rate, is always higher than the equity rate of return as long as the stock has a achieved a positive return.
But the problem is, almost no one reaches the full TSR potential available to them. As Mauboussin explains:
“First, most individuals do not reinvest the dividends they receive from the stocks they hold directly. While no definitive public statistics exist, individual investors appear to reinvest just 10 percent of the dividends they collect…Second, unless investors own individual, dividend-paying stocks in a tax-free account, they have to pay taxes on their dividends. This means that they can only reinvest a fraction of the dividends they receive, which prevents them from earning the TSR.”
The bottom line
Overall, buybacks and dividends have similar qualities but treat different groups of shareholders differently. Buybacks only benefit continuing shareholders when the stock is undervalued while dividends treat all investors equally.
You can read Michael Mauboussin’s full PDF at ValueWalk.com where the original version of this article was first published.