According to Michael Mauboussin, in the perfect world, dividends and stock buybacks are the same. However, we don’t live in an ideal world, and as a result, in practice, these two methods of returning cash to investors yield very different results.
In a research paper published in 2012, Mauboussin looked at the fundamental differences between these two cash return methods, reaching some exciting conclusions.
The difference between buybacks and dividends
The first fundamental difference is the impact of taxes on returns from buybacks and dividends. Even if the tax rate is the same on buybacks as it is on dividends, buybacks offer the better alternative for taxpayers as they can defer when the taxable gain is booked.
Concerning capital gains, the investor will only pay taxes on profits when they choose to sell the investment. Dividend taxes are paid when the dividends are distributed, the timing of which the investor has no control over.
According to Mauboussin, the second fundamental difference between the two is “how executives think of them.” For example, it tends to be the case that executives think of dividends on par with investment decisions such as capital spending. Once a board has instituted a dividend “executive like to increase the payment steadily over time and hate the idea of cutting it.” On the other hand, buybacks tend to be thought of as an alternative to spending excess cash. As a result, buybacks tend to be more sporadic and less predictable.
Still, this does not mean that buybacks are less efficient than dividends -- in fact the opposite is true.
Not reflected in the numbers
Mauboussin points out that investors frequently use past total shareholder return (TSR) as a guide to anticipate future returns (TSR = g + d(1+g) where g is the annual rate of price appreciation and d is the dividend yield). However, few, if any investors actually receive this rate. To do so, investors would have to invest 100% of dividends back into the stock. In contrast, companies that return cash to shareholders via buybacks allow their ongoing shareholders to earn the TSR as the cash is a) reinvested automatically and b) tax-free.
But what about income? Some investors, particularly retirees, depending on the income from their shareholdings to fund day-to-day spending. If companies cut all dividends, then this income stream would evaporate. Mauboussin argues that this is not a bad thing and investors, rather than relying on uncontrollable dividend payouts, should make their own dividends by selling shares if and when they need. This synthetic dividend means that there’s no reinvestment risk and little friction between the investor and stock.
Another question Mauboussin asks is “If you own the shares of a company because you believe the stock is undervalued, why would you ever want the company to pay a dividend instead of buying back shares?” Surely, if you’re buying a stock because you believe that it’s undervalued, rather than taking a dividend (and opening yourself up to reinvestment risk) you would rather management engaged in a buyback to reduce the discount to intrinsic value? If a company is buying back stock when it’s trading below intrinsic value, then it’s creating further value for investors without the chance of value-destroying acquisitions.
As Warren Buffett (Trades, Portfolio) wrote in Berkshire Hathaway’s 1984 annual report, “When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.”
The bottom line
So overall, the argument for/against dividends comes down to one fundamental issue: tax.
Taxes placed on dividend payouts hurt investors and damage the reinvestment rates available. If no tax were due, an investor would be able to reinvest the capital received back into the stock, which would bring returns closer to the untaxed TSR figure. Unfortunately, this also assumes that there are no dealing costs and the reinvestment price does not move between the date the dividend is issued (ex. dividend) and the time of reinvestment -- with some careful planning this could be possible but is it worth it?
Put simply, it looks as if buybacks are the better choice for investors.
Source: Share Repurchases from All Angles.
Disclosure: The author owns no stock mentioned.
