What’s Better: A Share Buyback or a Dividend?

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What’s Better: A Share Buyback or a Dividend?

By JLP | June 27, 2007

This morning Best Buy announced that it will buy back as much as $5.5 billion of its stock. Share buybacks are not uncommon but are they a good deal for shareholders? It depends. If the company is really intent on reducing the number of shares of stock outstanding, then it can be a good deal. Why? Because if earnings stay the same but there’s less shares outstanding, it means earnings per share will be greater. To see what I mean, take a look at this very simple example:

So, based on this example, a 20% decrease in the number of shares outstanding increased the earnings per share by 25% even though the earnings as a whole didn’t change. Notice how if the stock price stays the same, the P/E ratio goes decreases to 16 from 20. However, if the P/E ratio were to remain at 20, the stock price would move to $25.00 ($1.25 × 20 = $25.00).

NOTE: Remember that the P/E ratio is Stock Price ÷ Earnings Per Share.

From this example, a buy back seems like a pretty good deal. However, it’s important to note that a buy back isn’t always the best use of the company’s money. For instance, what is the stock price is high? It doesn’t make sense to use company money to buy something that might be overvalued. Also, many investors might prefer dividends instead (Best Buy did announce they were increasing their quarterly dividend to $.13 from $.10). At the new dividend rate, Best Buy will yield a little over 1.10% based on today’s stock price. That’s a pretty stingy dividend yield in my opinion.

In a lot of cases, I think it is a control issue. When a company pays a divdend, those dollars are gone. A buy back is different because companies might allocate money for a buy back but there’s no guarantee they’ll actually follow through. As a shareholder, I think I would prefer a dividend payment.

I have just touched on the very basics here. For more on stock buy backs, see this article on Investopedia.

Topics: Investing |

Comments to “What’s Better: A Share Buyback or a Dividend?”

Jordan Says:
June 27th, 2007 at 12:06 pm

Don’t forget the accounting differences between a buyback and a dividend. Each affects the books a little differently.

Also, buybacks are preferred if the company feels their stock is inappropriately depressed (and who better to know what their stock value should be than the company). If a company knows it has strong growth going forward, but is not ready to reveal all of this to the public, they may feel they can purchase back shares now at a discount over future share value. This action will further benefit remaining shareholders.

JLP Says:
June 27th, 2007 at 12:12 pm

Jordan,

Good points.

Nate Says:
June 27th, 2007 at 12:37 pm

Also, remember that a reason companies buy stock back is to increase the stock price (fewer shares available for purchase = higher demand = high price = potentially higher dividend for remaining shareholders). For a solid company like Best Buy, with their main big box competition (Circuit City) having issues, I’d rather hold onto the stock.

Jordan Says:
June 27th, 2007 at 1:10 pm

I sort of disagree with you Nate. Stock does not play by the rules of supply and demand in a pure sense. Because they are just pieces of paper, few of which will anyone other than a bank see, the rules of supply and demand are not completely in play. Stocks trade at value. If the value is low, and the price is high, people won’t buy. If the value is high, and the price is low, people want to buy. Ultimately, equilibrium is hit very quickly in the real-time of a stock market. Dividends are already factored into the price of a stock (watch stock prices drop as soon as the dividend date of record passes), as is almost all public information about a company and its future prospects.

If a company is buying back stock, or declaring a higher-than-expected dividend, it means that the company has run out of projects with positive NPV beyond their cost of capital. In theory at least, if a company does not have a project that will return value in excess of the average returns in the stock market, they should return that money to the shareholders via dividend or buyback, so that the shareholders can determine what they would prefer to do with the money.

Sorry - got a little off topic…but you see my points.

broknowrchlatr Says:
June 27th, 2007 at 1:13 pm

First, is it a lwa that companies have to announce that they are buying back stocks? If they announce it, the price will then be inflated as they buy back. In your example, I think the stock price on the buy back will vary from $20-$25. So, they would be unable to really buy back 50,000,000 shares. As such, the final price would be around $23 or $24. If that is the case, I think it is not good for the company or the long term holder, who gets a $3-$4 gain per share rather than a full $5 if it was a dividend.

Also, is it insider trading if a company uses earnings info to decide when to rebuy. At my company, I have access to most of the financial data and i can tell what the quarter to date numbers are and see if we are on track to hit analysts predictions for the end of the quarter. I wonder if companies are allowed to use this to determine whether to buy back or dividend.

M Says:
June 27th, 2007 at 1:53 pm

I’d rather have real money in my pocket versus a potentially temporary paper gain any day.

I would imagine that companies would prefer buybacks if they had a lot of employee compensation tied up in stock options.

Rob Says:
June 27th, 2007 at 2:14 pm

A stock buyback should theoretically have the same net effect as the declaration of a dividend. The price shouldn’t inflate that much from a buyback because while there will be fewer shares available, the company is spending its own cash to buy the shares, so there will be fewer shares in a company that has less cash and is therefore worth less. A dividend should actually lower the stock price because the company pays out the cash and there are still the same amount of shares outstanding for a company with less assets (cash). Thus, stock prices typically fall the day a company pays a dividend (or on the cutoff date to be eligible for it). You end up with a lower stock price + cash. Both are seen as positive signals because management believes it has the liquidity to afford the dividend or buyback. This isn’t always the case though. I remember GM’s stock price dropped a lot last year even though it was paying a huge dividend because results were so bad that people didn’t think the company could afford to go on paying it. And then they cut the dividend in half and the stock price didn’t react that much because people were expecting it and actually thought it was a good move to conserve cash for the company.

A stock buyback is better than a dividend for the investor (assuming the investor doesn’t prefer to reinvest the money elsewhere) because the dividends are taxed immediately while appreciation in the stock price is only recognized if/when you sell the stock. However, even if you want to invest the money elsewhere, you can sell that stock and buy something else.

kurt Says:
June 27th, 2007 at 2:43 pm

Earnings are NOT the same after a buyback. The funds have to come from somewhere and it either reduces interest income (if they used cash) or increases interest expense (if they used debt). You have the general direction right, but you missed a huge issue.

kurt Says:
June 27th, 2007 at 2:45 pm

“I would imagine that companies would prefer buybacks if they had a lot of employee compensation tied up in stock options.”
Stock options are typically adjusted for one-time dividends for exactly this reason (remember, not only insiders have options in a company and to keep them from getting “cheated” by a large one-time dividend [which will lower the stock price on the ex date] their strikes are adjusted downwards).

LegalTherapy Says:
June 27th, 2007 at 3:06 pm

A share buyback (unlike a dividend) is also a strong signal that the company thinks its shares are undervalued.

That’s typically why share buyback announcements cause a bump in the share price. Conversely, that’s also why an announcement of a share issuance causes a drop in price (i.e., the company’s willing to issue more shares at current market prices because they think the shares are overvalued (or at least, NOT undervalued)).

broknowrchlatr Says:
June 27th, 2007 at 3:13 pm

Doesn’t this have to do with the source of the money. If it is from any one time event, buyback is the way to go. If you gave a one time bonus dividend, the price would temporarily inflate, but then drop down.

If it is from income, increasing the dividend is better becasue it is permanent and will also affect the stock price.

Steve Says:
June 27th, 2007 at 3:23 pm

I wonder if it also has to do with where they are on the growth cycle. There are only so many Future Shops/Best Buys you can pump into any given town before you aren’t getting enough additional business to justify it, and considering the big box growth spree of the last decade, I wouldn’t be surprised if that’s the case, and they will be moving from a “growth and market share” focus to a “milk the profits from our cash cow” phase. That being the case, they probably don’t need as much capital, especially as it frees up as the buildings depreciate. Sort of a “thanks for helping us grow, here’s your money back with a little somethin’ somethin’ for your trouble”.

Jordan Says:
June 27th, 2007 at 4:22 pm

It might be worth noting that there are certain transaction costs that are lost completely during a share buyback that are not present in one-time bonus dividends (you have to pay some firm to manage the buyback). These monies completely leave the company, so at times, the extra dividend may actually put more money in the hands of the stockholder.

Of course, if you think your stock is undervalued…

Or you want to protect your shareholders from having to realize taxes on dividends (especially if your company is heavily held by large institutions/funds not expecting the large dividend)…

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Sam Says:
June 28th, 2007 at 3:00 pm

’d rather have real money in my pocket

William Abernathy Says:
June 30th, 2007 at 11:02 am

I would rather have the dividend. In fact the plan that I have implemented requires a stock that pays a good dividend.

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July 1st, 2007 at 11:03 pm

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Payday loan Says:
October 19th, 2007 at 2:44 pm

Last year may have set a record for share buybacks, but on the evidence of the past week British companies have lost none of their appetite for repurchasing their own stock.

Over the past five days alone, four FTSE 100 stalwarts, BT Group, Compass Group, Enterprise Inns and National Grid, have announced plans to mop up an additional £5.4 billion worth of their own shares. Given that corporate Britain is estimated to have spent £46 billion on buybacks in 2006, a heady 64 per cent increase on the previous year, declarations of intent to acquire a sum of more than one tenth that tally in a single week indicates that 2007 should be another banner year. Nor is this purely a domestic phenomenon. On Wall Street, the likes of ExxonMobil, GE, Goldman Sachs and Microsoft are mopping up their own shares with brio. S&P 500 companies are estimated to have bought back $110 billion (£55.6 billion) of stock in the first quarter of this year, on top of the $800 billion they have spent in the previous two years. Payday Loan Cash Advance

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What’s Better: A Share Buyback or a Dividend?