There are two main ways for a company to return capital to its shareholders: dividends and share buybacks. While both have their own advantages, the factors that drive the choice between a dividend or buyback varies from investor to investor.
A dividend payment allows a company to distribute its earnings to its shareholders. Dividends are typically paid in cash quarterly, biannually or annually. Even though dividend payments are based on the company’s earnings and are never guaranteed, shareholders usually like to see dividend payments to increase steadily over time.
On the other hand, a share buyback happens when a company purchases its shares on the open market to reduce the number of outstanding shares which will increase per-share earnings and increase shareholder value. (Fewer outstanding shares = higher stock price and earnings per share)
So, which approach is best for investors? Let’s look at both options from four different angles.
1. Tax efficiency
When picking between a dividend and a buyback, the tax efficiency of each option depends on several factors, including the tax rates and tax residency of the shareholders themselves. Generally, buybacks are more tax efficient than dividends for investors in developed markets.
Here’s an example for a U.S. investor in the U.S. market. With a dividend, the company pays out a portion of its profits to shareholders, who are subsequently taxed based on their individual ordinary income tax bracket. With a buyback, the company repurchases shares from the open market and then cancels them, thus reducing the number of outstanding shares. The shareholder doesn’t need to pay any taxes at the time of the transaction. Instead, the shareholder will have to pay long-term capital gains taxes on any profit when the stock is sold (usually less than the ordinary income tax rate).
Foreign investors investing in the U.S. market, on the other hand, do not have to pay any capital gains tax, but dividends are subject to a 30% withholding tax, which means an investor will only receive 70 cents for every $1 dividend paid out by their investment.
In places where dividends and capital gains are not taxed, such as Hong Kong and Singapore, fundamentally, there are no differences in terms of value creation between buybacks and dividends.
So, buybacks may be the better option for investors looking to minimize their tax liability in most instances. However, it’s important to note that this can vary depending on each individual’s tax situation.
2. Cash flow
Dividends provide a steady cash flow that can be used for reinvestment or to cover living expenses for investors. While dividend payments may fluctuate depending on the company’s profitability, many companies tend to pay a fixed portion of their earnings as a dividend (called the payout ratio) regardless of their stock price. As long as the company continues to pay a dividend, shareholders will continually see a return on their investment.
Buybacks, on the other hand, don’t generate any cash flow. Therefore, the entire return is only realised when the shares are eventually sold. However, one may argue that with the emergence of discount brokers, dividends are no longer necessary because shareholders can sell the company’s shares whenever they want without incurring high fees to achieve their desired cash flow stream. However, selling your shares may only make sense when the price is high during a buoyant market. It is much less palatable to sell them when prices are low during a market crash.
Dividend payments discourage companies from holding excessive cash, which management could spend on reckless endeavours such as bad acquisitions. Instead, a dividend-paying company must remain focused on executing its business to maintain (or grow) its dividend and shareholder confidence.
On the other hand, bad management can easily lead to irresponsible use of buybacks which destroys shareholder value. For example, executive compensations are often tied to earnings metrics, and management can misuse buybacks to boost earnings superficially in the short term. This might give them a nice bonus, but it ultimately harms shareholders’ value in the long term.
When a company pays a dividend, each shareholder receives cash proportional to their shareholding, regardless of whether they ‘need’ the money. Consequently, an investor who does not require the money for spending will have to look for the best opportunity to reinvest their dividends, which may be a challenging and time-consuming effort for some.
Whereas for buybacks, you’re essentially putting your faith in the company’s management and allowing them to do what they think is best with the company’s money. While buybacks may seem the easier option, it’s important to remember that you’re giving up some control. Therefore, it is crucial to understand a company’s capital allocation strategy if you’re planning on investing in one that prioritises buybacks. For these reasons, dividends are often seen as a more flexible reinvestment option for investors.
The fifth perspective
Both dividends and buybacks have their pros and cons. Dividends generate a steady stream of cash flow which is great for investors looking for passive income to fund their lifestyle expenses. On the other hand, share buybacks are a tax efficient way to increase value for shareholders if used responsibly.
Ultimately, it depends on what the investor is looking for. If they need regular income, a dividend might be a better option. If not, share buybacks in the hands of competent management is a great way to build ownership in a high-quality company over time.