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Buying back shares vs dividend


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http://seekingalpha.com/article/1320881-an-open-letter-to-bob-benmosche?source=yahoo

 

I came across this article which highlights a very smart and disciplined strategy used by American Capital to chose between the two. This makes a lot of sense especially for financial companies who are quite dependent on book value since it represents basically their authorization level on how much business they can do.

 

While this makes sense, for any company that generates excess funds, a small reliable dividend is more appropriate in my view along with the bigger portion allocated between buybacks and a special dividend if you will. I think it would be the best way to attract long term shareholders and reward them in the process.

 

There has been some debate about BAC's latest choice of buyback vs dividend. It seems that they have made a choice along the lines of American Capital. However, the 1 penny a quarter does not meet the test of a small reliable dividend IMO. It represents a yield of about 0.3% or about what people can receive in a savings account currently. It is not enough to entice people to look at this holding and think it is a good "saving instrument". A more appropriate level would be closer to a 10 year treasury at the moment which is an alternative to investors. For more normal times, a yield close to the inflation rate would make sense. This combined with the annual or quarterly "bump" going to a buyback or special dividend could create a special attachment between investors and their company and would represent very sound capital allocation for their managers: you get long term holders and disciplined managers.

 

Mathematically, we all know that there is a breakeven point between buybacks vs dividends. However, to apply it in practice and explain it to a board, investors and other constituents is quite difficult. You would need to know very well your future earnings power and along with the unavoidable hiccups would turn out into an art vs science. The approach above would be crystal clear, simple and would make more sense that what is out there for most currently which seems to be a game of handing out candies once in a while to boost the share price. What do you guys think?

 

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If a low dividend deters a certain group of investors from investing in BAC, then the buyback will potentially be more beneficial.  If the low dividend keeps the stock price down then BAC will have the opportunity to buy back more shares at a lower price.  Seems like a good strategy to me.

 

 

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Hey all:

 

Buybacks are good, for sure.  HOWEVER, there are some problems associated with this. 

 

A). Companies have a BAD habit of buying back stock near the top...

 

B). Companies can announce buybacks, and then only partially follow through.  In fact, I suspect this may be a common strategy.  We've authorized a 2 trillion share buyback!  A year later, how many shares have been bought back?  150.  The follow through needs some improvement!

 

C). Buybacks are not as regular as dividends, in that dividends are usually quarterly.

 

I think companies should retain a lot of their earnings, but they clearly ARE NOT distributing enough to us shareholders.

 

A). Dividends have a habit of focusing management's attention.  They know they need to make the next quarterly payment or there is going to be some fallout.  It focuses their attention.

 

B).  It prevents companies from having weak bladders.  How is that?  How many cash rich companies have you seen that just COULD NOT HELP THEMSELVES FROM PISSING IT AWAY?  Overpriced acquisitions (HP I'm looking at you), empire building, foolish expansion, etc.  Dividends are a great way to relieve pressure on the corporate bladder.

 

C). Dividends are a great way for shareholders to reduce risk.  Over years, you can reduce your cost basis to zero or LESS THAN ZERO. 

 

D). Unfortunately, I've got more ideas than capital.  My regular dividends allow me to diversify and try out different ideas.  I took my latest payments and bought 300 shares of AERL.  Not a big investment, haha, but it is something, and it is something brought about entirely by dividends!

 

I like buybacks, but I guess I'm "old school" and prefer dividends.

 

Just my thoughts...

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I prefer buybacks. I'm investing in companies that I think are undervalued, so I perceive buying back shares as a better use of capital than returning it to shareholders. I would NEVER own a stock where I would think buying back shares would be a mistake.

 

It's probably different from a management perspective if they also own a large part of the company. They don't have the same flexibility with buying and selling, so when they think buying back shares isn't a good investment they should prefer to pay a dividend.

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Scenario 1: 

A)  I buy a stock at 150% of intrinsic value

B)  It pays a $1 dividend and I pay 30% tax on it.

C)  I have 70 cents of cash

 

Scenario 2:

A)  I buy a stock at 150% of intrinsic value

B)  It uses that same $1 to repurchase shares and I in turn sell $1 worth of shares (no tax due)

C)  I have 100 cents of cash

 

 

So it's much better to buyback shares when stock is heavily overvalued (if the alternative is dividends).

 

 

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Scenario 1: 

A)  I buy a stock at 150% of intrinsic value

B)  It pays a $1 dividend and I pay 30% tax on it.

C)  I have 70 cents of cash

 

Scenario 2:

A)  I buy a stock at 150% of intrinsic value

B)  It uses that same $1 to repurchase shares and I in turn sell $1 worth of shares (no tax due)

C)  I have 100 cents of cash

 

 

So it's much better to buyback shares when stock is heavily overvalued (if the alternative is dividends).

 

I am afraid I don't completely agree..

 

At a 150% overvaluation, isn't the company buying back a 66 cents dollar bill for 1 dollar?

 

Which I think is rather value destructive as a shareholder of this company?

 

I would think that buybacks are optimal as long as the stock is undervalued, fairly valued and overvalued just until the level that the tax implication on the dividend will be less value destructive than the buyback..

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Scenario 1: 

A)  I buy a stock at 150% of intrinsic value

B)  It pays a $1 dividend and I pay 30% tax on it.

C)  I have 70 cents of cash

 

Scenario 2:

A)  I buy a stock at 150% of intrinsic value

B)  It uses that same $1 to repurchase shares and I in turn sell $1 worth of shares (no tax due)

C)  I have 100 cents of cash

 

 

So it's much better to buyback shares when stock is heavily overvalued (if the alternative is dividends).

 

I am afraid I don't completely agree..

 

At a 150% overvaluation, isn't the company buying back a 66 cents dollar bill for 1 dollar?

 

Which I think is rather value destructive as a shareholder of this company?

 

I would think that buybacks are optimal as long as the stock is undervalued, fairly valued and overvalued just until the level that the tax implication on the dividend will be less value destructive than the buyback..

 

The company is buying what the shareholder is selling.  So the overvaluation is a wash, the cash transfers to the shareholder without taxation.

 

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I guess it depends on the type of scenario within the buyback scenario, no?

 

1) I sell all my shares in the repurchase program and manage to sell a 66 dollar bill for 1 dollar. After the transaction I have no interest in the company and the value destruction does not matter anymore.

 

2) For example purposes, I sell half my shares (making the 66 dollar bill, 1 dollar gain as above) and keep half my shares. The IV of these shares declines as the company has done value destructive repurchases

 

3) I keep all my shares and am the biggest loser as the company did value destructive repurchases in which I did not participate

 

Is this a sound reasoning or am i talking friday evening nonsense?

 

Thanks, I like the thought experiment

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Scenario 1: 

A)  I buy a stock at 150% of intrinsic value

B)  It pays a $1 dividend and I pay 30% tax on it.

C)  I have 70 cents of cash

 

Scenario 2:

A)  I buy a stock at 150% of intrinsic value

B)  It uses that same $1 to repurchase shares and I in turn sell $1 worth of shares (no tax due)

C)  I have 100 cents of cash

 

 

So it's much better to buyback shares when stock is heavily overvalued (if the alternative is dividends).

 

You will have more cash with the dividend, but wouldn't the IV of the dividend paying stock be higher than the one who bought back?

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You will have more cash with the dividend, but wouldn't the IV of the dividend paying stock be higher than the one who bought back?

 

Less cash with the dividend I believe you meant to say.  Assuming a dividend tax of course.

 

Dividend paying stocks don't have more IV.  They just return cash differently.

 

The IV of $1 distribution is $1 (before tax) no matter how you slice it.  But the tax man slices it, and that's why dividends are *always worse if you pay taxes.

 

* Unless your capital gains tax rate is substantially higher than your dividend tax rate -- and your cost basis is very very low.

 

But nearly always it's better to repurchase shares no matter how high they trade.  Usually it's only someone like Berkshire Hathaway that pays a 35% tax on capital gains versus a 14.5% tax on dividends.  Oh, and how ironic it is that he is always bitching about buybacks unless the price is ridiculously low.

 

 

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The company is buying what the shareholder is selling.  So the overvaluation is a wash, the cash transfers to the shareholder without taxation.

If the stock is overvalued, you should use it as currency for acquisitions.  Even Buffett does that sometimes.

 

Otherwise, just sit on cash and wait for opportunities.  Buffett kind of did that going into 08/09.  He had liquidity to take advantage of situations like the BAC and GS preferred deals.

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Scenario 1: 

A)  I buy a stock at 150% of intrinsic value

B)  It pays a $1 dividend and I pay 30% tax on it.

C)  I have 70 cents of cash

 

Scenario 2:

A)  I buy a stock at 150% of intrinsic value

B)  It uses that same $1 to repurchase shares and I in turn sell $1 worth of shares (no tax due)

C)  I have 100 cents of cash

 

 

So it's much better to buyback shares when stock is heavily overvalued (if the alternative is dividends).

 

It isn't fair to use taxes in these comparisons as these are different per jurisdiction (also you conveniently left out US capital gains tax in scenario 2).

 

I pay 0% dividend-tax and, 0% capital gains tax. In the Netherlands we pay 30% tax on a fictive 4% yield on your net worth minus ~21k euros (so if I lose money I still pay this ;)). I can fully deduct foreignly withheld dividend taxes (to avoid double taxation).

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Eric, assuming that a company redistributes 1$ through share buybacks, the share price would rise with the equivalent of 1$ all else being equal. Capital gains tax will therefore not be avoided.

 

I'm no expert on US tax kaw though, so please inform me if my assumptions are faulty.

 

Also to OP, as you probably know Buffett has an excellent passage on share buybacks vs dividends in this year's annual letter.

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I prefer buybacks. I'm investing in companies that I think are undervalued, so I perceive buying back shares as a better use of capital than returning it to shareholders. I would NEVER own a stock where I would think buying back shares would be a mistake.

 

Amen!

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You will have more cash with the dividend, but wouldn't the IV of the dividend paying stock be higher than the one who bought back?

 

Less cash with the dividend I believe you meant to say.  Assuming a dividend tax of course.

 

Dividend paying stocks don't have more IV.  They just return cash differently.

 

The IV of $1 distribution is $1 (before tax) no matter how you slice it.  But the tax man slices it, and that's why dividends are *always worse if you pay taxes.

 

* Unless your capital gains tax rate is substantially higher than your dividend tax rate -- and your cost basis is very very low.

 

But nearly always it's better to repurchase shares no matter how high they trade.  Usually it's only someone like Berkshire Hathaway that pays a 35% tax on capital gains versus a 14.5% tax on dividends.  Oh, and how ironic it is that he is always bitching about buybacks unless the price is ridiculously low.

 

Remaining shareholders would be hurt by a buyback at prices above intrinsic value.  Yes, you can sell your shares back to the company above intrinsic value.  However, if you have large unrealized gains in a great business it may not be beneficial to sell if the intrinsic value is expected to increase significantly over time.  If a company is buying back its shares at 2X its intrinsic value i would be reluctant to maintain an investment with that management no matter how great the business is.  If management is buying back shares at a 30% premium in a great business and I have significant unrealized gains I would likely stick around even though management is destroying value slightly.

 

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The shareholder that sells when a company buys back shares at above intrinsic value is better off since in most jurisdictions capital gains tax is less than income/dividend tax. (Not in all cases, for example, in Canada, "eligible" dividend tax rates are lower than capital gains tax rates for certain tax brackets.)

 

However, the value destruction applies to the shareholder's that are not selling to the company. There's a trade-off point where, at a certain amount above intrinsic value, it may be still accretive to the shareholder on an after-tax basis, but above that point, it would not be. Time value also plays a role especially if it's a long-term holding.

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Scenario 1: 

A)  I buy a stock at 150% of intrinsic value

B)  It pays a $1 dividend and I pay 30% tax on it.

C)  I have 70 cents of cash

 

Scenario 2:

A)  I buy a stock at 150% of intrinsic value

B)  It uses that same $1 to repurchase shares and I in turn sell $1 worth of shares (no tax due)

C)  I have 100 cents of cash

 

So it's much better to buyback shares when stock is heavily overvalued (if the alternative is dividends).

 

If XYZ buys back 10% of its stock at a 50% premium to IV, the IV of all the remaining shares decreases by 5%. If I understand you, you prefer this route to dividends with the idea that you're better off for having avoided a dividends tax?

 

Of course, the alternative for capital allocation isn't just dividends.

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Eric, assuming that a company redistributes 1$ through share buybacks, the share price would rise with the equivalent of 1$ all else being equal. Capital gains tax will therefore not be avoided.

 

I'm no expert on US tax kaw though, so please inform me if my assumptions are faulty.

 

Also to OP, as you probably know Buffett has an excellent passage on share buybacks vs dividends in this year's annual letter.

 

 

Let's say IV for the shares is $66 and they buy them back at $100.  How much do they buy back?  They buy back the equivalent of otherwise paying a $1 dividend per share.

 

You own 100 shares of this stock that you purchased at $100 per share.  So you would otherwise be getting a $100 cash dividend on your 100 shares.  You would owe $30 dividend tax on your 100 shares at 30% tax rate.

 

But instead we're talking about buybacks:

Now, if your cost basis is $100, you owe no tax if you sell 1 share to get your $100 "dividend".

 

If you sell at $101 per share as you suggest, and therefore $1 per share of capital gains tax is due.  Then you still sell roughly 1 share to get your $100. 

 

So if the capital gains tax rate is also 30%, then you owe 30 cents of capital gains tax.

 

 

So it's $30 in dividend tax versus 30 cents in capital gains tax.

 

I'd rather pay 30 cents than 30 dollars.  Wouldn't you?

 

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Scenario 1: 

A)  I buy a stock at 150% of intrinsic value

B)  It pays a $1 dividend and I pay 30% tax on it.

C)  I have 70 cents of cash

 

Scenario 2:

A)  I buy a stock at 150% of intrinsic value

B)  It uses that same $1 to repurchase shares and I in turn sell $1 worth of shares (no tax due)

C)  I have 100 cents of cash

 

So it's much better to buyback shares when stock is heavily overvalued (if the alternative is dividends).

 

If XYZ buys back 10% of its stock at a 50% premium to IV, the IV of all the remaining shares decreases by 5%. If I understand you, you prefer this route to dividends with the idea that you're better off for having avoided a dividends tax?

 

Of course, the alternative for capital allocation isn't just dividends.

 

 

Keeping it simple...

 

The company wants to return $1 per share to you.  You own 100 shares.  So you are getting $100 returned to you.

 

The company returns it to you by purchasing $100 worth of shares on your behalf at 150% of IV.

 

You in turn sell $100 worth of shares at 150% of IV.

 

The amount of IV they destroyed by purchasing at 150% of IV was entirely recaptured by your sale at 150% of IV.

 

Absolutely no damage to you.  In fact, you win by owing far less in taxes.

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However, the value destruction applies to the shareholder's that are not selling to the company.

 

Correct. 

 

However one might ask why they still want to hold the shares at 150% of IV.  It seems they are missing out on a great opportunity to sell, and why complain if the company is willing to buy?

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Yeah but if you follow that line of thinking your scenarios wouldn't exist in the first place, as no sound (value) investor would buy at 150% of IV

 

I agree with you there.

 

The math is the same no matter where the price point is.

 

The reason why I chose a lofty valuation for the example was to put to rest this myth that dividend are always better than buybacks when valuations are steep. 

 

You can't really do any myth busting without testing it in the lab.  There is a TV show called Myth Busters that I'm referring to.

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