Dividends vs Buybacks

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While the company’s decision to choose between paying dividends and making a share repurchase/buyback depends on a number of factors, we will discuss the fundamental differences between these two from the investor’s perspective.

 

Basic Definitions

Dividends are the distributions to shareholders from the company’s earnings, usually paid at regular intervals, e.g. monthly, quarterly, or yearly.

Similar to the dividends, share repurchases or buybacks are also considered cash distributions to shareholders, but in contrast to directly being paid to shareholders, they are repurchased back from them in the stock market typically at a premium to the market price.

Companies choose one of these methods or a mix of these two to distribute excess cash to shareholders. The decision is based on multiple factors, such as the under/overvaluation of the share price, the message the company aims to convey to its shareholders, potential investment opportunities, etc.

Below we will discuss the choice between these two methods from the point of view of an investor. The factors to consider will clearly vary from investor to investor, but the four aspects that we will discuss give a general overview of pros and cons of dividends and buybacks.

Types of Investors

Would you prefer the company you’ve invested in to pay you a regular dividend or initiate a stock buyback program? This depends on what type of investor you are and what are your investment goals.

Generally cash dividends are a good choice for the ones who prefer stable income over their investment time horizon, or who rely mainly on this source of income, or maybe a retiree who need to cover his/her daily expenses from this cash distributions.

On the other hand, long-term investors are more concerned about future prospects of the company and capital gains, rather than current income in form of dividends. So buybacks will be more desirable for them.

However, the preference between these two is not so clear. A lot of other important factors have to be taken into consideration, such as tax considerations, which is discussed next.

Tax considerations

From tax perspective, the major difference between dividends and buybacks is that the former is taxed in the current period, while the latter on a future date when the shares are sold. In case of buybacks, one has to consider the taxes on long-term capital gains, which are taxes on holding a stock that is appreciating in value over time. But, generally capital gains are subject to lower taxes in comparison to dividends.

Certainty

Another important aspect between these alternatives is the difference between relative certainty and continuance of dividends and buybacks. Dividends are regular payments and are seldom cancelled or reduced by the companies, as this kind of decisions adversely affect the stock price. So companies resort to cutting or eliminating dividends only in critical times.

The situation is different with buyback. The company has no obligation to implement the buyback program as initially reported. It can change both the timing and the amount. There is no certainty about the buybacks, while with dividend the investor has significant guarantees that he/she will receive a predetermined income over some time horizon.

Company Prospects

Dividends and buybacks may convey important information about the company. The decision to initiate, cancel, increase or decrease dividends or start a buyback program may have a huge impact on investors’ behavior and significantly affect the stock price.

Theoretically, the management initiates a buyback program when it thinks the shares are undervalued. So this can be interpreted as a positive sign for investors.

Moreover, with the reduction of outstanding shares, some metrics such as EPS, P/E ratio, ROA will be improved, which in turn can drive the share prices higher.

Conversely, buybacks can indicate the lack of profitable investment opportunities for the company and send a negative signal to long-term investors.

 

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