The Secret About Buybacks

Friday, February 22nd, 2019

By: Kevin Shuller, CFA®

Poor share buybacks. They are everyone’s punching bag right now. From politicians to the New York Times Opinion page, everyone is taking their turn whacking the pinata.

We never see headlines calling for the increased regulation of dividends. Everyone loves dividends. Dividends put cash in your pocket. Many of us are old enough to remember getting dividend checks in the mail. No one ever received a stock buyback check. Here’s a little secret. Dividends and stock buybacks are the same thing.

When a company generates free cash, there are only a few actions they can take:

  • Reinvest in the business – buying new equipment, spending on R&D, hiring new people, etc.
  • Mergers and Acquisitions – the company can buy another company and merge the operations.
  • Pay back its investors:
    • To lenders by paying down debt.
    • To shareholders by paying dividends or by buying back shares.

Whether the company sends cash or buys shares, the company is paying its owners. Sometimes it is doing it with cash; sometimes with increased ownership in a company. Shrinking the share count makes each share represent more of the company.

The biggest pushback against buybacks should be that corporate management teams are, on average, horrible at it. Corporate managers tend to buy back shares when they can, not when they should. Managers tend to buy back stock when the company is doing well because that’s when they have extra cash. The stock also tends to be above fair value when the company is doing well, too. Buying shares when the stock is overvalued destroys value for remaining shareholders.

A big difference between dividends and share buybacks is the tax implications. If a company pays a dividend, that dividend is taxable for the shareholder. If the company buys back shares with that money instead, it isn’t taxable. Investors wouldn’t pay taxes until they sell. If they never sell, they never pay taxes.

There is an in-depth, arcane accounting proof for dividends and share buybacks being the same thing. From the investor’s perspective, dividends are taxable now, buybacks are taxable when you sell. Dividends put cash in your pocket whether you want it now or not. Buybacks give you the flexibility to sell shares when you need the cash. At the end of the day dividends and share buybacks represent companies returning extra capital to its owners. Why should one be demonized and the other idolized?