February 14, 2012
Dividends and stock buybacks, however, vary in one vital respect. Dividends distribute cash to all shareholders whereas buybacks distribute cash only to those shareholders who sell their shares. In the case of stock buybacks, investors can choose – they can sell and receive cash or retain their shares which, all other things being equal, will reflect an enhanced value due to the higher earnings per share or some combination thereof. Fundamentally, however, dividends and share repurchases are both mechanisms by which a firm returns cash to its shareholders in lieu of its other options – retention, debt repayment or capital investment.
Some analysts are reluctant to view share repurchases as a means of returning cash to shareholders since the popularity of employee stock options as a form of compensation has led to offsetting share issuance and dilution. However, with the release of Financial Accounting Standards No. 123 (revised 2004) and the subsequent FASB ASC 718, public companies since 2005 have been recording the cost of share-based compensation on their income statements. Employee-share based compensation which has averaged over 4% of annual selling, general and administrative expense since 20072 is now appropriately recognized as an expense. Hence, stock buybacks should be viewed for what they are – a mechanism to return cash to shareholders.
The combination of dividend and share buybacks provides a better picture of cash returns to shareholders than dividends alone. As illustrated in the following graph, since 2005 the share buyback yield (i.e. share buybacks as a percent of stock market value as shown in red) has exceeded the dividend yield (in blue) with the sole exception of the credit crisis. In total, the dividend and buyback yield is now in excess of 6%, a similar level to the payouts of six decades ago.
There are issues with buybacks. Management may benefit inappropriately from what is really financially engineered earnings growth. Many buybacks are poorly timed when the stock is expensive. Buybacks are also more volatile than dividends.
However, from an affluent investor’s perspective, buybacks have many advantages. Investors can control the timing of their sales and critically, are not forced to realize taxable income as in the case of dividends. Long-term investors can defer taxes by relying on faster earnings per share growth to drive unrealized capital appreciation. At any time, they can create a synthetic dividend by simply selling stock. In tax jurisdictions such as Canada where capital gain tax rates are lower than dividend tax rates, the synthetic dividend will have much lower tax drag.
Market history demonstrates that investor love affairs usually end badly. Investors should quit looking solely at dividend yields and move to a total, after-tax return perspective that encompasses stock buybacks.
Tacita Capital Inc. is based in Toronto, Canada and is a private, independent family office and investment counselling firm that specializes in providing integrated wealth advisory and portfolio management services to families of affluence. We understand the challenges of affluence and apply the leading research and best practices of top financial academics and industry practitioners in assisting our clients to reach their goals.
2. Thompson, C., J, Muraco, and A. Robinson, 2011, “Has share-based compensation entered the “new normal” too?” Stout Risius Ross Journal.
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