Treasury Practice

Give and take – share buybacks vs dividends

Published: May 2020

When a company is doing well, it can use its cash to enhance shareholder value through dividends or by share buybacks. We go back to basics with these two closely connected themes.

Gold coins - dividends

A business that is doing well will often have what is known as retained earnings – the portion of net income it keeps in a separate account. This can be used in a variety of ways, such as funding expansion or major capital projects. However, retained earnings can also be used to pay dividends or to repurchase its shares in the open market.

Share repurchases (or buybacks) and dividends are a means by which publicly traded companies can return cash to their shareholders. A company can fund its buyback by taking on debt, with cash on hand, or with its cash flow from operations. A set of corporate principles, known as a ‘pay-out policy’, will typically guide the value of any proposed cash dividends and share buybacks.

In practice, a buyback will see the company buy its own shares from the open marketplace, effectively cancelling these to reduce the number of freely trading shares (or ‘share float’) in the market (hence a buyback is sometimes referred to as a ‘float shrink’). The company can also make a tender offer, where existing company shareholders are asked if they wish to tender some or all of their shareholdings within a certain time frame; the offer includes the number of shares the company wishes to acquire and its offer price range.

Conversely, dividends are offered as a share in the company’s profits on a discretionary basis. These are paid out or ‘distributed’ at regular intervals to shareholders, mostly as cash but sometimes as shares of stock or other benefits. Dividends are declared (authorised) by the board of directors. Their value or distribution may be constrained by debt covenants.

Of the two, buybacks are usually seen as the more tax efficient, if less direct, way to return capital to shareholders. Whereas dividends are a definite taxable return and are subject to different tax treatments at both the corporate and personal levels, buybacks have uncertain value and tax is deferred until the investor sells.

Returns on share buybacks can never be guaranteed, but with corporate cash pools increasing, they appeared to be on the rise, especially in the US. In 2018, US companies saw a peak buyback of US$866bn, Apple alone undertaking US$100bn in buybacks during that year.

However, according to the FT in February 2020, citing preliminary figures from S&P Dow Jones Indices, US corporates bought back US$736bn of their own stock in 2019. This was down 19% on 2018. On the other hand, a record-breaking US$485.5bn was paid out in dividends, with 2019 now the second year in a row that more than US$1trn was returned to shareholders.

Why dividends?

Dividends are a share of company profits, paid at regular intervals to its shareholders. Its directors are free to distribute dividends at whatever value they see fit, on the proviso that they are derived only from company net profits.

Not every company pays dividends. Rarely will a start-up or high-growth company offer a pay-out. These businesses often report losses in their first few years. If there are profits, these will often be ploughed back into the business.

Dividends are usually associated where a mature business has notable positive (and predictable) income streams and profits. These companies may not exhibit the huge growth curves of their formative years, but as established market players, dividends (usually paid at a higher rate than more dynamic/less predictable businesses) can boost overall returns for those that have invested in the company’s stock.

Cash is the most common pay-out but some companies issue shares of stock as an alternative. According to Standard & Poor’s, since 1932, cash dividends have made up about one-third of the total returns on US stocks, with the remainder coming from price appreciation, or capital gains, on that stock.

Dividends have two main roles: to signal to investors that the company is healthy and has a future, and to attract investors by paying them a regular income, possibly increasing the market value of the company’s stock.

There are several reasons why a business may choose not to pay dividends. If rapid growth is part of its strategy, then earnings can be invested back into the company. That business may also wish to use its cash to fund M&A activity. Conversely, a business that is perhaps not so strong may choose not to pay dividends simply to avoid the negative impression it gives to the market should it ever need to stop paying or lower its pay-out.

Types of dividend

Although cash tends to be the preferred form, dividends may take several forms. The list includes:

Cash dividends

As the most common form, cash dividends issued per share are simply a cash payment whose value has been calculated by using the dividend per share (DPS) formula shown below.

Other forms may be known as distributions-in-kind. These may be used as a means of reducing corporate tax liabilities that may arise from, for example, an increase in an asset’s value.

Stock dividends

As an alternative to cash, a number of shares may be awarded to each shareholder based on the amount of shares they hold. This may be done on a pro-rata rights basis. This is not obligatory in terms of offer or uptake but the idea is to ensure that extra share issuance does not dilute the existing ownership or voting rights of the shareholder, maintaining their percentage of equity stake at the same level.

Property dividends

Dividends may be offered as an asset such as property, plant, and equipment (PP&E), which is generally highly illiquid, or inventory, which is more liquid.

Scrip dividends

Sometimes a company will offer its shareholders a choice of either receiving a cash dividend or the equivalent in additional shares of the company. Scrip issues are usually offered when there is insufficient liquidity for a cash dividend to be paid. By increasing the number of shares, these secondary issues will dilute share value but they are exempt from stamp duty as they are not an investment per se – even though investors can sell them on the open market (at which point they are subject to capital gains).

Liquidating dividends

This is an end-of-the road dividend where all assets are liquidated and the remaining proceeds (if there are any) after satisfying creditors are paid out to shareholders as a dividend. Creditors are always senior to shareholders in such a case. A liquidating distribution usually only occurs where a solvent business is in voluntary liquidation.

How much?

The main calculation used to decide the value attributed to each individual share in a dividend pay-out is DPS. DPS determines total income for each investor, based on share ownership.

DPS formula

graphic 1

There are two version of DPS calculation:

DPS = total dividends paid/number of shares outstanding

or

DPS = earnings per share x dividend pay-out ratio (This figure is the expected percentage of profits returned based on historical dividend pay-outs, which could be in the region of 50%, or as low as 20%.)

Basic EPS takes the net income applicable to common shares for the period and divides it by the average number of shares outstanding for that same period.

Why buybacks?

Both buybacks and dividends are of interest to market analysts because, as distributions to shareholders, they affect investment returns and financial ratios. One of the major benefits of a share buyback is that it reduces the number of shares outstanding for a company. Share repurchases made with excess cash (as opposed to debt) therefore can increase per-share measures of profitability, notably cash flow per share (CFPS) and earnings per share (EPS) which are key metrics for investors when assessing stock values.

Buybacks can enhance EPS, even when the company is reporting otherwise unexceptional top-line and bottom-line growth. This may see the business being given a higher valuation by investors, and as long as the price-earnings (P/E) multiple at which the stock trades remains unchanged (P/E = current stock price divided by EPS), the buyback should drive up the share price.

Indeed, the FT recently noted that share buybacks “have played a role in bolstering the stock market to record highs by reducing the share count and boosting company earnings per share”. It said that the S&P 500 ended last year (2019) up nearly 30%, “even as underlying profits growth stagnated”.

Firms that often buyback their own shares can grow EPS at a faster rate than by its normal business activities alone, especially for well-established market leaders. It is a way of attracting investors, especially as it also demonstrates the power to generate sufficient cash to buy-back its own shares in the first instance. However, the buyback process has been seen as a way of manipulating key financial metrics such as EPS, and has even been criticised as signifying a lack of imagination within the business, in that if the business has nothing better to do with its cash than buy its own shares, then has it run out of ideas, and is thus a poor long-term investment.

Impact on financial statements

Reducing outstanding shares has an effect on a company’s income statement and other financial statements. The balance sheet will see a reduction in cash holdings, and thus its total asset base, following a buyback (to the value of the buyback). Shareholder equity will also lower on the liabilities side by the same level.

As well as increasing EPS, buybacks reduce the assets on the company’s balance sheet – cash – and so will similarly improve the health of other financial performance metrics such as the aforementioned P/E ratio (simply because fewer outstanding shares, but with the same earnings, equates to a higher EPS and thus better P/E), return on assets (ROA) and return on equity (ROE).

The cost of a buyback programme will normally be reported in the following quarterly earnings statement, although the total spend should also be visible in the company’s Statement of Cash Flows, under Financing Activities, and in its Statement of Changes in Equity and Statement of Retained Earnings.

Dilution effect

To keep senior executives happy, public firms can give their employees the right to buy the company’s stock at a specified price for a finite period (good value for the employee if the stock rises and they exercise their option and then sell those shares – usually with vesting controls put in place by the company – on the open market). But employee stock option plans, if issued in significant numbers, can dilute EPS and P/E by adding shares to the market, weakening these key metrics.

Regular dividends can signify corporate stability, keeping shareholders keen and attracting new investors, but once on that pathway it is difficult to leave without damaging after-shocks.

A business that has pursued stock options (or indeed one that has seen M&A result in new shares being issued, or perhaps has issued dilutive securities such as stock warrants or convertible preferred stock) may elect to minimise the effects of dilution, reducing the number of outstanding shares through a buyback programme.

Diluted EPS (and all potential dilution) has to be reported under GAAP as an adjustment of the basic EPS. In a profitable business, diluted EPS is always lower than basic EPS (as profit has been spread amongst a greater number of shares), just as in a loss-making business, diluted EPS always shows a lower loss than basic EPS because the loss is spread out over more shares.

Which is best?

There is no definitive answer as to which is best; both have advantages and disadvantages. Here’s a brief list of pros and cons:

Buyback advantages
  • Gainfully deploys expensive-to-hold cash, and signals healthy liquidity of the business.

  • Boosts key valuation metrics such as EPS and CFPS, making the business look more attractive to investors.

  • Counters market undervaluation: companies buy low then re-issue upon market correction.

  • Pays off investors and reduces overall cost of capital.

  • Flexibility for company to engage with the market when it is ready to do so.

  • Little or no market negativity when buybacks are reduced or halted.

  • Tax efficient for investors; deferred until stock sold and then subject to a capital gains rate. If held for more than one year, a lower capital gains rate may apply.

Buyback disadvantages
  • Shareholders may expect excess cash to be better used for investment activities such as a new manufacturing plant, increasing market presence, R&D or M&A activity.

  • Wise investors can see through buybacks designed simply to increase key financial metrics (or pay large bonuses to senior executives).

  • Buybacks can be a sign that the company has few profitable long-term opportunities, at least in its current form.

  • Can affect a company’s credit rating if it borrows money to buy-back ie taking on debt never outweighs an EPS boost.

Dividend advantages (for a stable dividend policy, as opposed to irregular distributions)
  • Signals ‘business as normal’, giving shareholders and potential investors confidence.

  • Stabilises market value of shares.

  • Meets the needs of institutional investors who can only invest in companies with stable dividends.

  • Can improve the company’s credit standing and make access to financing easier.

Dividend disadvantages (again, for a stable dividend policy)
  • Difficult to suspend or cease pay-outs once started.

  • Suspension or cessation can see knee-jerk stock disposal by investors.

  • Suspension or cessation can negatively affect the market price of shares.

  • Less tax efficient for investors (subject to ordinary income tax, with no deferrals).

  • Paying dividends despite financial difficulties is potentially ruinous.

Shareholder happiness = corporate happiness

Listed companies operate to keep their shareholders happy. Buybacks increase a stock’s value, but knowledgeable investors will ask if that is just a short-term boost for certain financial ratios or over-compensating of executives. Regular dividends can signify corporate stability, keeping shareholders keen and attracting new investors, but once on that pathway it is difficult to leave without damaging after-shocks.

If the financial benefit of both is considered on behalf of the investor, there are two US indices that might steer opinions one way or the other. The S&P 500 Dividend Aristocrats includes only companies that have managed to raise dividends annually for at least 25 consecutive years. S&P’s equivalent for signalling active buyback companies is the S&P 500 Buyback Index, which lists stocks with the highest buyback ratios, defined by cash paid for share buybacks in the last four calendar quarters, divided by the company’s market capitalisation.

S&P reports that between March 2009 and March 2019, the annual return on the S&P 500 Buyback Index was 21.09%, whereas the Dividend Aristocrats Index delivered an annual return of 19.35%. The standard S&P 500 posted an annual return of 17.56% over the same period.

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