When a company is profitable and generates more cash than what to do with, CEO and the board now have to make critical decisions with respect to capital allocation – and it is often the best use of time of the CEO to ponder about capital allocation and delegate the day-to-day operations to other members of c-suite, such as chief operating officer.
Capital allocation can be divided across a few things – internal investment, external investment (mergers and acquisitions or partnerships), capital expenditure, dividend and share buybacks.
Today- i want to focus on comparing dividend and share buyback and let you decide which is better for your stocks. For me- I think buybacks are better for following reasons.
SHAREBUYBACKS ARE TAX EFFICIENT WAY TO RETURN CAPITAL TO SHAREHOLDERS THAN DIVIDED
Dividends go through double taxation. The company pays income tax according to its pre-tax income and then you pay tax on the dividend when you get the dividend income. So there is corporate tax and then personal income tax.
And corporates (except for pass-through entities like REITS) do not get any tax benefit from paying out generous dividends.
HOWEVER, if the company buys back shares in the open market, it increases % ownership that each share represents – effectively you gain a greater ownership as there are FEWER shares outstanding. This obviously does not provide immediate stock price “boost” so to speak, but increases earnings and value per share – helping long-term price increase if all else equal.
Not to mention, if the company continues to reinvest and increase the value AND you hold the stock for over a year, you will pay long-term capital gains tax on the incremental value from reinvested cash that would have been paid out to investors but with dividend tax rate(higher than long term capital gains tax).
SHARE BUYBACK CAN BE STRATEGIC AND OPPORTUNISTIC WHILE DIVIDENDS ARE NOT
Once a company starts paying dividends, there are often expectations that the company will continue to pay dividend and management teams often are under pressure to prioritize stable dividend over others because the stock price often gets destroyed with dividend cuts.
However, share buybacks are generally not perceived to be recurring – yes, companies can stop buying back shares, but the stock price does not get penalized for stopping buybacks.
Often companies just have a large share repurchase program (authorized by the board) and buy back shares opportunistically.
Companies can buy back shares at low multiple and take arbitrage. Let’s say a company usually trades at 12x P/E and due to earnings miss, the stock gets smoked to 8x P/E. Company can buy back stock at 8x – this would be a highly accretive transaction if company is confident on trajectory medium term.
BUYBACK SUPPORTS STOCK PRICE AND DAMPENS VOLATILITY
This is a more of a trading dynamic, but if a company has a large buyback program in place and investors know that, there is generally support for the stock on the downside because investors know that there is the buyer of the last resort. Short sellers are less probe to be heavily involved because they know companies will support the stock with its cash on its balance sheet.
Also, they know that outstanding shares are decreasing – making the borrow (to short the stock) more expensive and the position more risky EVERYDAY.
Stability of trading price may not have impact on fundamentals, but it definitely helps psychology of its investors- it is better to hold a stock that moves +/-5% on a monthly basis than a stock that moves +/-20% on a monthly basis.
I THINK TESLA COULD START DOING SOME BUYBACKS
Tesla has A LOT OF PLACES to be deploying capital – but they have also invested a LOT already as capital expenditure – building out multiple GIGA factories.
All the equipment and properties will now generate outsized non-cash expenses like depreciation that will PRINT MONEY FOR TESLA as tax shield (not to mention, they just move their corporate HQ to Texas – probably with large tax breaks).
It does not need to be in billions, but buying back stock, even to just offset dilution from employee stock options, could help stabilize stock prices (pushing paper hands to sell) and allow staunch long-term investors that never sell to reap the benefit long-term on a tax-efficient basis.
WHAT ARE YOUR THOUGHTS ON BUYBACK VS DIVIDEND? Please leave in the comment below.
happy investing!
*not investment advice
