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Returning value through share repurchases rather than dividends


twacowfca
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Example:

 

A company with 100 shares outstanding has annual cash earnings of $10 ($0.10/share). The company’s stock trades for $1.00/share. The company has a stable business and continues to earn the same $10 each year for an indefinite time. None of its earnings are needed for reinvestment in the company.

 

The company decides to use all its earnings to repurchase shares. The price per share is assumed not to increase for nine years, despite buying back shares. Each succeeding year, using its earnings, the company repurchases 10 shares at the same attractive price of $1.00/share.

 

Nine years later, the holders of the 10 shares that remain outstanding have the right to $1.00 of earnings per share. Rationalization of the share price would suggest a much higher price per share, perhaps 10 X earnings or $10.00/share. (If the price per share did not rationalize, the next year’s purchase of the first 9 of 10 remaining shares would mean the owner of the last share would own the whole company.)

 

The rationalized gain in the price per share after 9 years is much more than dividends per share of $0.90 ($0.10 yearly for 9 years) that could have been distributed annually in lieu of repurchasing shares. The contrast in value remains even after allowance for reasonable gain from reinvesting the dividends.

 

This example suggests that repurchasing shares whenever a stock sells below intrinsic value is a superior way of returning quantitative value (not necessarily perceived value) to remaining shareholders than paying dividends even when taxation of dividends is not a drag on returns.

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In your example, you wind up with each share earning more money on a per share basis.  In the dividend example, the shareholder simply winds up with more shares (if they keep buying more shares with the dividend).  There is no extra value added in the buyback scenario -- it's just that the reinvestment of the earnings is automated and it feels cool psychologically to see the EPS growing at a faster rate.  Then again, you might enjoy watching the number of shares held grow.  It's entertaining either way.

 

Taxation on the dividend is the bugaboo -- without taxes you could just have a DRIP take care of it and then the dividend would do the same thing as a stock buyback plan.

 

 

There is an important point I haven't mentioned yet:

 

Should I ever own shares in a company that is buying back stock and if I am caught complaining that the price is too high for buybacks, then I should ask myself a question:  Why do I still own it if I don't like the price?  Take the money and run.

 

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In your example, you wind up with each share earning more money on a per share basis.  In the dividend example, the shareholder simply winds up with more shares (if they keep buying more shares with the dividend).  There is no extra value added in the buyback scenario -- it's just that the reinvestment of the earnings is automated and it feels cool psychologically to see the EPS growing at a faster rate.  Then again, you might enjoy watching the number of shares held grow.  It's entertaining either way.

 

Taxation on the dividend is the bugaboo -- without taxes you could just have a DRIP take care of it and then the dividend would do the same thing as a stock buyback plan.

 

 

There is an important point I haven't mentioned yet:

 

Should I ever own shares in a company that is buying back stock and if I am caught complaining that the price is too high for buybacks, then I should ask myself a question:  Why do I still own it if I don't like the price?  Take the money and run.

 

 

Please take a closer look at the example cited.  Receiving a dividend of $0.10 per year would enable the holder of one share to buy one tenth of a share per year or a little more than .90 additional shares after nine years.  The 1.9 shares owned after nine years would then be entitled to $0.19 earnings per year ( actually slightly more than that because of some compounding on the dividends received ).  Even allowing for that compounding that might add a few more cents, this amount would be quite a bit less than the $1.00 in earnings that would be available to the holder of one share in the buyback example.  :)

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In your example, you wind up with each share earning more money on a per share basis.  In the dividend example, the shareholder simply winds up with more shares (if they keep buying more shares with the dividend).  There is no extra value added in the buyback scenario -- it's just that the reinvestment of the earnings is automated and it feels cool psychologically to see the EPS growing at a faster rate.  Then again, you might enjoy watching the number of shares held grow.  It's entertaining either way.

 

Taxation on the dividend is the bugaboo -- without taxes you could just have a DRIP take care of it and then the dividend would do the same thing as a stock buyback plan.

 

 

There is an important point I haven't mentioned yet:

 

Should I ever own shares in a company that is buying back stock and if I am caught complaining that the price is too high for buybacks, then I should ask myself a question:  Why do I still own it if I don't like the price?  Take the money and run.

 

 

Please take a closer look at the example cited.  Receiving a dividend of $0.10 per year would enable the holder of one share to buy .90 additional shares after nine years.  The 1.9 shares owned after nine years would then be entitled to $0.19 earnings per year, quite a bit less than the $1.00 in earnings that would be available to the holder of one share in the buyback example.  :)

 

Yes of course that works out as you say -- it's not because I'm wrong though, rather it's because  the example is BS.

 

You are saying that in the buyback world the market cap would shrink every year, and further you are comparing it to the dividend world where you assume the market cap would remain constant.

 

 

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The example is extreme, but the point is still valid.  In the real world , I can only recall one example where a company was able to buy back the great majority of its shares for a price that was less than IV without moving the share price.  This was when Jay Pritzker bought back all the minority shares in The co that owned the cocoa beans using payment in kind. WEB and BG made a nice profit on that deal, but Pritzker made out like a bandit.  Simply by holding on to his shares, he wound up owning shares in that co that were worth many times the price per share that the stock traded for before that astonishing operation.

 

If a company,like Lancashire for example, buys back 25% of its shares over three years,paying less than BV and far less than IV, this will add more value per share than if the same amount of money had been paid out in dividends.  :)

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The example is extreme, but the point is still valid.  In the real world , I can only recall one example where a company was able to buy back the great majority of its shares for a price that was less than IV without moving the share price.  This was when Jay Pritzker bought back all the minority shares in The co that owned the cocoa beans using payment in kind. WEB and BG made a nice profit on that deal, but Pritzker made out like a bandit.  He wound up owning shares in that co that were worth many times the price per share that the stock traded for before that astonishing operation.

 

Pre-Paid Legal Service has had a nice buyback program as well. My guess is that in 5-7 they won't be able to purchase shares anymore. Then the dividend is next.

 

BeerBaron

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The example is extreme, but the point is still valid.  In the real world , I can only recall one example where a company was able to buy back the great majority of its shares for a price that was less than IV without moving the share price.  This was when Jay Pritzker bought back all the minority shares in The co that owned the cocoa beans using payment in kind. WEB and BG made a nice profit on that deal, but Pritzker made out like a bandit.  Simply by holding on to his shares, he wound up owning shares in that co that were worth many times the price per share that the stock traded for before that astonishing operation.

 

If a company,like Lancashire for example, buys back 25% of its shares over three years,paying less than BV and far less than IV, this will add more value per share than if the same amount of money had been paid out in dividends.  :)

 

 

I could start a thread titled "Returning value through dividends rather than repurchases".  I would then start that thread using an example where a company buys back roughly 10% of market cap every year.  The stock moves up each year such that the market cap remains a constant.  The company keeps buying shares back at market price and in doing so, the stock keeps moving up and up.

 

Then I would compare it to another company initially trading at $10 that paid a 10% dividend (a $1 dividend), where the stock price kept dropping by $1 annually but where the absolute amount of dividend paid remained a constant at $1.  Thus, each year the dividend yield keeps heading higher and higher, as the market cap keeps getting lower and lower.  I reinvest the dividend each quarter in the ever-cheaper shares.

 

Pretty soon I'm in the position of owning the entire company in the dividend example, whereas I'm nowhere close to doing so in the share buyback scenario.

 

Therefore, I've shown that dividends increase value better than buybacks.

 

Okay, truce alright?  I've created an equally BS scenario as yours -- neither is correct.

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In both examples, the following is the case:

1)  one method keeps buying shares at ever lower market cap (thus getting a better value every year)

2)  the other method keeps buying shares at a constant market cap (thus getting the same value every year)

 

The only conclusion these examples show is that it's a better value to purchase the exact same company at a lower market cap than at a higher market cap.  It leads to no valid conclusion as to which of the two methods is better for returning value to shareholders.

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Guest Bronco

Are these stocks that went up due to buybacks, or companies that were going up and did buybacks?

 

Also, Buffett never did a buyback in 40 years.  What do you guys know that he doesn't?

 

Enjoy the debate, but I won't beat this too death.  My last post on this.

 

Need to check out FFH this weekend while trying to avoid my inlaws.

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Also, Buffett never did a buyback in 40 years.  What do you guys know that he doesn't?

 

 

But, Buffett has said on multiple occasions that Henry Singleton of Teledyne is one of the greatest capital allocators in history and should be studied. Singleton was really successful in using a combination of buybacks and issuing shares to take advantage of when his stock was undervalued / use his stock as currency for deals when it was overvalued.

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Singleton and Biglari (lol) thus far have the best ideas on buybacks. Use them as a tool.

 

Issue shares when stock is over valued, and buy back back when its not only cheap but one of the best available investments to you. FFH, BRK, Loews, and Lancashire all know what they are doing and have all used buybacks effectively when needed.

 

My company sucks at this, they buy high, and dont buy when things get rough. Its what most companies do. The worst ones even sell new shares when things get rough. I prefer dividends from all but owner manager companies. Its hard to screw up a dividend but buybacks get screwed up everyday.

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Can I have my brownie points?  ;)

 

Berkshire Hathaway 1999 Chairman's letter:

 

Recently, a number of shareholders have suggested to us that Berkshire repurchase its shares. Usually the requests were rationally based, but a few leaned on spurious logic.

 

There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down.

 

    The business "needs" that I speak of are of two kinds: First, expenditures that a company must make to maintain its competitive position (e.g., the remodeling of stores at Helzberg's) and, second, optional outlays, aimed at business growth, that management expects will produce more than a dollar of value for each dollar spent (R. C. Willey's expansion into Idaho).

 

(...)

 

Recently, when the A shares fell below $45,000, we considered making repurchases. We decided, however, to delay buying, if indeed we elect to do any, until shareholders have had the chance to review this report. If we do find that repurchases make sense, we will only rarely place bids on the New York Stock Exchange ("NYSE"). Instead, we will respond to offers made directly to us at or below the NYSE bid. If you wish to offer stock, have your broker call Mark Millard at 402-346-1400. When a trade occurs, the broker can either record it in the "third market" or on the NYSE. We will favor purchase of the B shares if they are selling at more than a 2% discount to the A. We will not engage in transactions involving fewer than 10 shares of A or 50 shares of B.

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Can I have my brownie points?  ;)

 

Berkshire Hathaway 1999 Chairman's letter:

 

Recently, a number of shareholders have suggested to us that Berkshire repurchase its shares. Usually the requests were rationally based, but a few leaned on spurious logic.

 

There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down.

 

     The business "needs" that I speak of are of two kinds: First, expenditures that a company must make to maintain its competitive position (e.g., the remodeling of stores at Helzberg's) and, second, optional outlays, aimed at business growth, that management expects will produce more than a dollar of value for each dollar spent (R. C. Willey's expansion into Idaho).

 

(...)

 

Recently, when the A shares fell below $45,000, we considered making repurchases. We decided, however, to delay buying, if indeed we elect to do any, until shareholders have had the chance to review this report. If we do find that repurchases make sense, we will only rarely place bids on the New York Stock Exchange ("NYSE"). Instead, we will respond to offers made directly to us at or below the NYSE bid. If you wish to offer stock, have your broker call Mark Millard at 402-346-1400. When a trade occurs, the broker can either record it in the "third market" or on the NYSE. We will favor purchase of the B shares if they are selling at more than a 2% discount to the A. We will not engage in transactions involving fewer than 10 shares of A or 50 shares of B.

 

 

You not only get five Brownie Points, but a Gold Star as well!  :)

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If done correctly, share repurchases are usually preferable to dividends. Double taxation is an important issue with dividends. Corporations are taxed on earnings before paying the dividend, and then investors are taxed (at a higher rate than capital gains) on the dividends. Also, remember that share prices generally fall my the amount of the dividend, so it's questionable how much value you are really gaining from dividend payouts.

 

The problem, as mentioned earlier in this thread, is that a lot of companies buy back their shares at bad times. Boards approve buybacks over periods of several years, and companies often buy back their stock regardless of the stock price. In March of 2009 when stocks were highly undervalues, almost no companies were buying back their own stock. Now that stocks are up, companies are announcing buybacks.

 

For example of horrendous capital allocation regarding share buybacks, look no further than Eddie Lampert. He lost huge amounts of shareholder money buy buying back large amounts of SHLD stock at around $150 a share, and then again when it was at around $120 a share.

 

The company I work for recently announced a couple billion $ in buybacks that will be funded by new debt, which is questionable (but could work at ok in the long run).

 

Anyone of have a list of companies/management buying back their own stock in early 2009?

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Also, remember that share prices generally fall my the amount of the dividend, so it's questionable how much value you are really gaining from dividend payouts.

 

You're right about taxes.  However, in a world without taxation the benefit is that you get the dividend paid at full intrinsic value.  It doesn't matter that the share price drops -- it's supposed to drop after a dividend is paid. 

 

I will provide now an example where the dividend adds value:

 

Let's say for example that you want to withdraw 3% annually from your investment account, but everything in your account is trading as a 50 cent dollar.  You have nothing trading at intrinsic value.  And we're in difficult economic times and this discount exists for years on end.  Your account is fully invested.  Do you sell shares for 50% below what they're worth?  Or let's say instead that you own dividend payers and your yield on your portfolio is at least 3% -- you can just extract the cash from your account at full intrinsic value, without needing to sell anything.

 

So dividends allow you to regularly extract full intrinsic value from your investments like clockwork.  A value investor should enjoy that aspect of it.  Isn't the whole point to purchase shares below intrinsic value and then realize full intrinsic value from your investments?  That's my understanding.  Selling shares for intrinsic value is very lumpy and it might never happen as for some companies the fair value at where they should trade could very welll be far below intrinsic value (prices take risk into account) -- when you need cash on a more consistent basis the dividend is the answer.  How long might you have been holding onto Fairfax shares waiting for full intrinsic value?  I like their dividend -- every January I get full intrinsic value on a portion of my investment.

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What about buyback mixed with a stock dividend? I believe it would be the most tax and shareholder friendly structure, the people that depend on the income can sell the share issued and the ones that want to keep them get the extra shares tax free.

 

BeerBaron

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So dividends allow you to regularly extract full intrinsic value from your investments like clockwork.  A value investor should enjoy that aspect of it.  Isn't the whole point to purchase shares below intrinsic value and then realize full intrinsic value from your investments?

 

Indeed, with dividend investments like KO, JNJ, PG, KFT; it allows the insurance players to get paid while holding their capital. I like that FRFHF is paying a dividend - since most of my FRFHF is in retirement accounts, it doesnt affect me with taxes and also allows me to reinvest the capital in other things.

 

 

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