Companies can put their cash to many uses. They can reinvest it back into the business, pay down debt, buy out a competitor, etc. They also can use the cash to reward shareholders.
The two main ways they can use cash to reward shareholders are through buybacks and dividends. Let’s examine the comparative merits of both avenues.
Benefits of a Buyback
As the name suggests, a buyback is when a company repurchases its shares. The company will either buy them on the open market or make tender offers to existing shareholders to buy their shares at a certain price. The repurchased shares are usually retired.
This helps shareholders by 1) supporting the share price, and 2) reducing the number of shares outstanding.
When a company’s board of directors authorizes a share repurchase program, it’s usually for at least hundreds of millions of dollars over time. The company acts as major buyer backing the stock.
Moreover, when there are fewer shares outstanding, each share is entitled to a bigger chunk of the company’s revenue and profit. This has the opposite effect to a dilution, which decreases the ownership stake of each share.
Easy Ratio Boost
For example, let’s say company XYZ has 100 million shares outstanding and it earned $100 million in net income. That comes out to an earnings per share (EPS) of $1. But if the company repurchased 10 million shares, the EPS will increase to $1.11 ($100 million / 90 million shares).
Even though the company is still making the same amount of profit, just by buying back shares, it increased its EPS by 11%. Since each share is entitled to more profits, it is more valuable. All things equal, the net effect of a stock buyback on shareholders is positive.
On the other hand, if the company has bad timing and the stock falls after the repurchase, the company would have “wasted” money. If the company had waited to buy, with the same amount of cash it could have bought more shares.
Ironically, the most obvious impact of a buyback on a stock’s price is at the announcement. The price will usually rise in reaction because the market now prices in the upcoming repurchases.
If the company is repurchasing shares on the open market, the actual buyback activity will blend into normal market activity, which means the public won’t know that the company has bought shares until after the fact. Unless you sell your shares, the way you benefit from a share repurchase is in unrealized gains.
What About the Dividend?
U.S. companies typically pay dividends on a quarterly basis. Every quarter, the company’s board will review the financials and vote whether to distribute a dividend and how big a dividend to pay. Every shareholder of record as of the record date will receive the dividend.
In contrast to a buyback program, when a company pays a dividend, you get cold hard cash directly. You are free to do whatever you’d like with the cash. Some companies even offer a dividend reinvestment plan (DRIP) whereby you can automatically reinvest the dividend into their stock.
The drawback to a dividend is unless you hold the stock in a tax-sheltered account or fall into a low-income bracket, the dividend will be a taxable event.
Which is Better?
From an investor’s perspective, if you want/need to get regular cash payments from your investment portfolio, you will probably prefer dividends. But if you would rather avoid paying the dividend tax and let your shares grow in value, you may prefer buybacks.
From a company’s perspective, share repurchase programs tend to be more flexible. It can buy shares at a timing of its choosing. For example, it can wait if the share price jumps too high too quickly or if business hits a rough patch. It’s also an easy way to boost ratios like EPS when the share price falls.
Of course, a company can also suspend or reduce its dividend during hard times, but the market usually will interpret it as a sign of financial trouble and punish the stock.
Still, having a firm commitment to a dividend policy is not a bad thing for a company. It gives shareholders a sense of security because they can count on getting a dividend payment every quarter. It also forces management to be more disciplined and conservative with cash management.
So what’s the final answer? The choice really isn’t mutually exclusive. Many companies choose to do both. Regardless, pay close attention to company policies on buybacks and dividends.
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