The average stock investor seeking cash returns from an investment often looks for dividends. What if I tell you there is a second and possibly better way of value creation for shareholders (the owners)?
Creating value for shareholders should always be the number one priority of a company. This value creation comes in many forms, but there are two practices that every investor must understand: dividends and share buybacks.
There are numerous ways of creating value for shareholders, and not all companies offer dividends or value-creating share buybacks. But the greatest investors in the world specifically look for companies that offer the best strategies for returning value to their shareholders.
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In recent years, there has been growing popularity in share buybacks, and many investors aren’t sure which will create more value. I’ll walk you through a simple way to compare value creation through dividends and share buybacks.
Investing Like a Capitalist
Viewing business and investment opportunities using a capitalist idea is quite simple from an investor’s standpoint.
- Investors put money into a business.
- The business earns a return on the capital through its operations.
- Over a period, the business gives back MORE capital to the investors than what they put in.
It’s as simple as that.
At the end of the day – all investors expect more money than their original investment at some point in the future.
Publicly traded companies have two primary ways of returning capital to their investors (the owners):
- Dividends; and
- Share buybacks
Which option is better for the investors? This depends on each investor’s situation, of course, but my goal is to help you evaluate these circumstances.
A Hypothetical Example – Green Sand, Inc.
Let’s use an imaginary company, “Green Sand, Inc.”
Green Sand, Inc. is a rock-solid company and continues to earn $100M in Free Cash Flow (FCF) each and every year going forward.
Free Cash Flow is the cash remaining after the company pays for its operating expenses (everyday costs of operations) and capital expenditures (large costs like buildings, and machinery). This represents the money from operations that can be used to pay back creditors, and investors.
Green Sand, Inc. also has 100M shares outstanding (100M total shares). This gives us a FCF of $1 per share each year. FCF/Shares Outstanding – $100M/100M shares = $1.
The management team for Green Sand, Inc. is not able to come up with an effective strategy to reinvest its earnings, so they have decided to return the money back to the owners (the shareholders).
The question now is: Should they pay it in dividends or buy back shares from the shareholders?
Dividends Distribution Example
Dividends are very straightforward. Green Sand, Inc. can issue a $1 per share dividend check to the shareholders each and every year.
For example: if you own 10,000 shares of Green Sand, Inc. you would then get a dividend check for $10,000 each year from the company, as your part of the ownership. (10,000 shares x $1 per share = $10,000). Your “cash inflow” from Green Sand, Inc. would look like this:
An Example of Share Buybacks
Green Sand, Inc. instead decides to do a share buyback. This means that some of Green Sand, Inc. owners will buy out the shares of other owners – for a sum of $100M per year. Green Sand, Inc. will go to the open market and purchase shares back.
We’ll assume the shares can be purchased from other shareholders at 20 times Free Cash Flow (FCF). Using a multiple of FCF is a common method of placing a value on the company – there are many methods, but this is one. This would mean that spending the $100M would enable Green Sand, Inc. to purchase and retire 5% of its shares. Thus, leaving 95M shares at the end of the first year.
The result – 5% of the existing shareholders would be selling their ownership stake in Green Sand, Inc. to the remaining 95% of shareholders – for $100M each year.
Over time, the owners that do not sell their shares back to Green Sand, Inc. will see their percentage of ownership continue to rise each year.
Fast forward 10 years. Green Sand, Inc. management decides to discontinue its share buyback policy after 10 full years. Thus, having reduced its total outstanding shares by about 40%. This is the net result of reducing by 5% each year, and in return, driving value to shareholders who held for at least 1 full year, but hopefully all 10 years.
Remember, in Year 1 there were a total of 100M shares outstanding. By Year 10, there will be roughly 60% of that 100M supply outstanding or ~60M shares outstanding.
This means that from Year 11 forward, the company now has only 60M shares and is still generating $100M annually. Each share will generate $100M / 60M shares = $1.67 in FCF for each share. This $1.67 can now be paid in the form of a dividend to the shareholders, rather than share buybacks. Assuming you held onto your 10,000 shares for the entire 10 years, you can now expect to receive 10,000 x $1.67 = $16,670 in dividends each year from Green Sand, Inc.
From the above example, we now conclude from our example that:
- If Green Sand, Inc. pays dividends from Year 1, you would get $10,000 per year.
- If Green sand, Inc. does share buybacks, you get nothing for 10 years and then $16,670 from Year 11 – forward.
Are Dividends Better Than Share Buybacks?
This will depend on how soon you want to use your money. If you value having your cash flow “today” you’d prefer having dividends because you would receive your dividends from Year 1. With buybacks, you don’t mind having your cash flows paid in the “future.” You will wait 11 years to begin taking your cash flow dividend payments in return for a larger payment. $16,670 rather than $10,000 in this example. Keep in mind that companies will not give you such future time horizons as guidance for dividends and share buybacks.
Discounted Cash Flow (DCF) Example
In the finance and investment world, there is a calculation to determine the tradeoff between “today” and “future” values – it’s called Discounted Cash Flow analysis or DCF. The goal of DCF is to help an investor determine a value of an investment based on future cash flows. The cash flow stream with the highest present value would be considered the better investment. Investors should remain on the conservative side when creating DCF models, simply due to the fact that estimating future cash flows is just that – an estimation.
Our example gives us a discount rate of 5.26% per year (see the formula below).
- This tells us for all discount rates above 5.24% per year, we would want dividends.
- For discount rates below 5.24% per year, we’d rather have share buybacks.
Discounted Cash Flow models use a “discount rate” input. The number helps investors quantify having the money “today” versus in the “future.” The larger the discount rate, the more we would value having the money “today” rather than in the future. Discount rates are a complete topic of their own, but providing the general idea provides context to understand the dividends and share buybacks concept.
Importance of the Discount Rate When Using DCF
This leads us to the next idea. The discount rate provides us with an opportunity cost of 5.24%. In simple terms – if you are a savvy investor earning more than 5.24% per year, you would likely rather have the dividend money so you can re-invest the capital yourself. Of course, each investor’s financial situation and investment capacity are unique.
Company management deciding to issue dividends or share buybacks know that they cannot appease every shareholder, but they are generally consistent in their actions. Great companies are exceptionally transparent in how they anticipate driving value back to shareholders and follow through with great execution. It is then up to the investors to make investment decisions based on their personal financial needs and expectations.
4 Factors to Consider When Analyzing Dividends & Buybacks
Dividend Obligation
There comes a time when every great company starts returning cash to its shareholders via dividends. This is a major step to ensure shareholder confidence. Once a company begins a dividend program, the owners and the general market will ‘expect’ this dividend to continue and to grow over time. This dividend becomes an obligation in the eyes of investors. Reducing or eliminating the dividend will have severe consequences for the share price.
Share Prices
Share buybacks reduce the overall supply of stock available on the market. A company that continues to drive value and deliver value to its shareholders is rewarded with higher demand for shares in due time. The reduction of supply and increased demand for the shares usually leads to an increased share price. This may work both – for and against – shareholders. When management implements a share buyback policy, sometimes it does not consider the price of each share, but it should. It could be purchasing shares at a price that shareholders believe is too expensive. This can affect the overall value it is returning to shareholders.
The example above does not consider share price because markets are not rational, and the real value is in the company’s growth and how it returns value to its shareholders.
Stock Based Compensation (SBC)
Stock based compensation has become extremely common in companies, especially over the last 15 years. This must always be looked at when analyzing share buybacks. For example, a company may be issuing large amounts of shares to its employees as stock based compensation (SBC) and only looking to buy back shares to offset the shares given to employees. In some cases, the company may issue new shares even while repurchasing shares resulting in a dilutive effect (adding more shares brings the FCF / share lower). Tracking all of this can be done within the 10-K filings of a company.
Taxes
Share buybacks are considered ‘tax efficient’ when compared to dividends. The reason is that when a dividend is paid to shareholders, the shareholder must pay tax on that money. Whereas, if the company purchases shares with its available cash, it adds value to shareholders without having a direct tax consequence for each shareholder.
Conclusion
The company management has an obligation to create value and return capital to its owners (the shareholders).
- The two best ways to return capital are through share buybacks and dividends.
- Investors often overlook the value creation of share buybacks and instead opt for companies that offer dividends – but both should be carefully examined.
- Dividend paying companies return value to the owners “today.”
- Whereas those looking for the “future value” of the company may opt for those doing share buybacks.
- Knowing how these two methods will impact the company and provide value to your investment is very important.
- Both methods provide valuable insight into the company and will help you determine the expected returns on your investment.
Frequently Asked Questions (FAQ)
What are dividends?
Dividends are a distribution of a portion of a company’s earnings paid out to its shareholders. Dividends can be in the form of cash, additional shares, or other property.
How often are dividends paid out?
Most dividends are paid out on a regular schedule, typically quarterly, semi-annually, or annually. However, the frequency can vary depending on the company’s dividend policy.
What are stock buybacks?
Stock buybacks, also known as share repurchases, occur when a company buys back its own shares from the marketplace. This reduces the number of outstanding shares, which can increase the proportion of shares a shareholder owns.
Why do companies buy back their own shares?
Companies might buy back shares for several reasons. Some common ones include to return excess cash to shareholders, to improve financial ratios such as earnings per share, to prevent dilution or to provide support to the stock price.
How are dividends taxed?
In many countries, dividends are taxed at a specific rate, often different than ordinary income. Some dividends, known as “qualified dividends” in the U.S., may be taxed at the long-term capital gains rate, which can be lower than the regular income tax rate.
How do stock buybacks impact investors?
When a company buys back its shares, it reduces the number of shares in circulation. This can increase the value of the remaining shares. It can also improve financial ratios, which can make the company appear more attractive to investors.
Are dividends and buybacks always a positive sign for investors?
Not necessarily. While dividends and buybacks can return cash to shareholders and potentially improve share value, they can also signal that a company doesn’t have better investment opportunities. Additionally, if a company takes on debt to finance dividends or buybacks, it could harm the company’s financial health in the long run.
How do I know if a company pays dividends or conducts buybacks?
Companies typically announce their dividend policy and any planned buybacks in their quarterly and annual reports. These are publicly available documents that can be found on the company’s website or through financial news and information services.
Can a company stop paying dividends or conducting buybacks?
Yes, a company can decide to stop paying dividends or conducting buybacks at any time. This decision is usually made by the company’s board of directors and might occur if the company needs to conserve cash or invest in other opportunities.
What is a dividend yield?
The dividend yield is a financial ratio that indicates how much a company pays out in dividends each year relative to its share price. It’s calculated by dividing the annual dividends per share by the price per share. A higher yield can indicate a greater return on investment, but it can also reflect a lower stock price or higher payout ratio.