“Do you know the only thing that gives me pleasure? It’s to
see my dividends coming in.”
That’s a quote from John D. Rockefeller, the first U.S. billionaire in history, and while investors today (hopefully) have other joys in life, many within the value investment community share Rockefeller’s love for dividends.
While dividends theoretically offer no benefit to investors (a stock’s price will decrease by the amount of the dividend), many investors believe they demonstrate disciplined capital allocation; a management team that commits to a dividend is less likely to pursue risky empire-building acquisitions. Dividends also provide investors with a tangible reassurance that a company’s earnings are real, that the business is actually making money and not relying on non-cash gains to boost profit numbers. But while dividends have accrued quite the cult following, there is an alternative to the dividend that gets a lot less love from the investment community, and that is the share buyback.
A share buyback is exactly what it sounds like; it’s when a company uses some of its own money to buyback shares from the market. These shares are effectively cancelled by the corporation, reducing the total number of shares outstanding. This increases each individual share’s claim to a company’s earnings since you are splitting the profits among fewer investors. Share buybacks don’t get nearly the same level of attention as dividends, but from a financial perspective, they actually provide a similar benefit to investors with an added tax advantage.
When a company buys back its shares, we tend to see the stock price increase as the buyback boosts earnings per share. Ignoring taxes, this increase in price should be equivalent to any benefit the investor would have received from a dividend; whether the company commits $1B to a dividend or a share buyback, they are returning the same amount of money to investors. But while investors must pay taxes on dividends as they’re received, buybacks don’t accrue any liability for the investor. In this way, they provide a deferred tax benefit; you will only pay taxes when you sell the position.
Now much like dividends, not all buybacks are created equal. A company will ideally only buyback its shares when the stock is undervalued; in the same way we strive to buy low and sell high, we want the companies we own to buy their own shares back at a low price. Many companies, however, try to consistently buyback their shares and actually pullback on their programs when valuations are down, when the program would have the largest impact on investors. So the timing of a buyback is important, while its less of a factor for dividends. Dividends are also favourable for income investors who intend to withdraw the cash from their accounts on a regular basis, as it saves them the transaction fee associated with selling a position.
But, for investors looking to reinvest their dividends as they come in, a buyback has its advantages, providing the same effect while avoiding transaction fees and taxes. For this reason, we aren’t so quick to limit our stock universe to companies that don’t pay a dividend.
It’s great to see the dividends of your stocks come in, but for the right price, I’m just as happy seeing fewer investors trying to take a piece of my profit pie.