Both dividends and stock repurchase schemes are ways that a company can boost the returns of its shareholders. However, whilst it is reasonably easy for an investor to understand how the payment of a dividend rewards him, many find the mechanism of stock repurchases more complex, especially when it comes to their benefits to shareholders.
What is a stock repurchase?
A stock repurchase program – also known as a share buyback program – is a mechanism by which a company buys back its own shares.
The company buying back its own shares can do so by either purchasing direct from the market (getting its broker to buy shares on the stock exchange) or it can ask if its shareholders wish to tender their shares at a fixed price.
A stock repurchase program has to be agreed at the annual general meeting, and the agreement will stipulate the amount of the buyback (usually in terms of total value, rather than number of shares) and the period during which the repurchase program may operate.
Why would a company conduct a stock repurchase program?
When a company wants to return cash to shareholders, it can, of course, do so by paying a dividend. However, if the company believes that its shares are undervalued by the market it might decide to undertake a stock repurchase program. The company believes that by taking shares out of the market it will increase the value of the remaining shares.
Often a company will announce the price at which any stock repurchase will take place, and this puts a ‘floor’ under the price of the shares traded on the stock exchange. Understanding how a stock repurchase can help the share price increase, however, is a little more complicated.
The first thing to understand is that the act of purchasing shares does no more harm to a company’s value than paying a dividend. Both methods of returning cash to shareholders take cash off the balance sheet and remove a certain value from the company.
However, in the case of a stock repurchase, because the shares bought by the company are then cancelled, there are fewer shares on the market. The overall value of the company is no different to if the return to shareholders had been made via a dividend payment, but the respective price per share will have increased.
Further, future dividend payments will likely be higher per share, because there are fewer shares for the dividend to be shared between. This will be another push on the share price.
So, share repurchases are a good thing?
This really depends upon the price of the shares and the value of the shares. Price and value are two different things. Just because the company is undertaking a stock repurchase program does not mean the stock is undervalued.
There are many measurements of value, and when considering whether the stock repurchase program is a good event, then an investor should look at ratios such as the price to earnings and fundamentals such as revenue, cash flow, and debt.
Having established the value of the company, perhaps relative to others or in an historical context, the investor will be able to say whether he would reinvest any dividends that would be paid to him, or perhaps commit new capital. If the answer is yes, then the stock repurchase program works in the investor’s favor.
Are there other benefits to a stock repurchase program?
We’ve already discussed the effects that a stock repurchase program may have on the share price, by cancelling stock and seeing the market capitalization of the company supported by fewer shares.
And we’ve seen that the payment of higher dividends will help drive the share price forward.
But there is also a tax advantage for shareholders. If the investor believes that the stock repurchase is being conducted at a good valuation, and would have reinvested his dividends anyway, then he will be gaining because the dividends he would have received would have been liable to tax at his personal rate.
The disadvantage of a stock repurchase program
Instead of buying shares in the market, the company could have paid its investors a higher dividend. This dividend could then have been used in any way the investor cared, including reinvestment, investment elsewhere, and to meet regular expenditure.
When the company buys its own shares, it is removing the capability of the individual investor to make the decision of what to do with dividend cash. Even if the investor would have reinvested, when the company conducts a share repurchase it is deciding when and at what price to do so and the investor has no control over this either.
Dividend payments give the shareholder a wide ranging flexibility of choice, stock repurchase take that choice away.
The attraction of dividends
Most companies pay dividends on a quarterly basis, though some do pay monthly, and this can produce a good regular flow of income for investors.
Those investors who don’t need the income can reinvest those dividends as they please to benefit from a compounding effect. This can greatly enhance investment performance over the longer term.
As a long term investment strategy, investing in stocks that pay a high yield, or those with dividend growth rates above the level of inflation, helps to protect purchasing power against the effects of inflation.
However, dividends are treated as taxable income, and will be liable to tax at the individual’s tax rate.
Stock repurchases or dividends: what’s best?
Stock repurchases should boost the value of shares and mean that dividend payments will be larger on a per share basis in the future. They also negate the tax effect that investors suffer when receiving dividend payments. If they are conducted at a price which would appear to attractively value the company, then most investors would agree that they are good news.
However, for those investors that require income, or want the flexibility to choose what to do with an otherwise higher dividend, the repurchase of shares by the company removes this flexibility.
The choice of whether to stick with the company that conducts a stock repurchase program will depend on the objective of the investment, and the investor’s valuation of the company.