Income seeking investors have one primary goal in mind – generating a regular income. We’ve discussed before how the best way to create a stream of income is via a diversified, rock-solid, portfolio of dividend-paying stocks.
From the investor’s perspective, dividends are hard cash evidence of the company’s earning power. If the company is able to generate a decent profit, the management may decide to reward long-term shareholders with a portion of the profits. Usually, the dividend yield on the stock is close to 2.5%, which is fairly better than a fixed income security.
However, cash dividends aren’t the only way companies reward shareholders. Sometimes they do something completely different with the money – they buy their own shares. A number of prominent companies currently spend billions of dollars buying back their own shares from the open market. Here’s how this share buyback scheme compares to a regular dividend:
How Buybacks Work
Companies choose to spend their cash on buying back shares to reward long-term shareholders. The theory is that by reducing the outstanding number of shares the company’s shareholders can own a bigger proportion of the company.
They’re meant to create value but they don’t always achieve this. Buybacks are only beneficial to shareholders if they’re done at the right price. For buybacks to create wealth, the price at which the company buys must be lower than the value of the share.
If the company can buy shares at below intrinsic value, the shareholders that hold onto their stake will benefit as the company grows and various metrics improve. The earnings and return on equity will improve when there are fewer shares and growing cash flows. A good indication of whether a stock is overvalued or undervalued is price-to-economic book value (PEBV). PEBV is an indicator of intrinsic value and if the company can buy stock at below a ratio of 1, it should be creating value for shareholders.
Although, that isn’t the only way to judge value. You can use the Dividend Discount Method we mentioned earlier or the price-to-book (P/B) ratio to see if the price is right. Warren Buffett, for example, claims Berkshire Hathaway will buy back shares when the market price of the stock reaches 120% of book value. According to him, at that rate the stock is clearly undervalued and worthy of purchase.
Another concern for most investors and firm managers is the rate of taxes. Tax rates on dividends are likely to be different than on capital gains. Qualified dividends are usually taxed at a lower rate, but you still have to pay stamp duty and various charges to receive the cash.
Buybacks, instead, can create wealth without affecting the investor’s annual tax liability. Avoiding a tax liability could be the primary reason so many companies revert to share buybacks. At the moment, US companies spend well over $600 million a year buying back their own shares.
Problems With Buybacks
There are, essentially, two problems with buybacks that can diminish their potential – Management can use the programs to manipulate financial metrics and purchases could be made at the wrong price.
Managers at multinational public companies are often paid in stock options. Sometimes, their annual salary could be closely linked to specific metrics like the EPS or the P/E ratio. Since a buyback improves these key metrics with minimal effort, managers could be tempted to spend cash on buybacks regardless of the price.
Another issue is the price of purchase. If the price is too high, the company is effectively destroying value by purchasing an overvalued asset. Back in 2007, General Electric spent a whopping $12.3 billion to buy back its shares. It kept buying for much of the past decade, spending a total of $44 billion on the intense buyback program. But the stock has declined by 15% over this same period. That means the company has lost a significant amount of value through the program.
Apple, on the other hand, has also spent a tremendous amount on share buybacks over the past decade. However, Apple stock was bought at an average of $117 while the stock now trades at $139. That means the shareholders have benefited by 18% wealth creation over the period.
Share buybacks can be as effective, if not more, than dividends at creating wealth for shareholders. Pay attention to the average price of purchase and the long-term tax implications of this move.