Finance 101 – The Difference Between a Stock Buyback and a Cash Dividend

There are many misconceptions floating around the internet on stock buybacks and their implications. Presidents, congress, and political commentators have scorned them for years as corporate greed, corporate mismanagement, or just down-right immoral! But what exactly is a stock buyback? And how do they differ from a cash dividend? Let’s try and cut through the noise and answer the question.

For clarity purposes, this analysis is from the perspective of C Corps in the US and US tax code. We’re not going to discuss REITs, Partnerships, etc. in this article. 


The Basics

A dividend is quite simple. A company makes a payment in cash, or on rare occasions in stock, directly to its investors. It is a way to return money to the investor who can do whatever they want with it, rather than it sitting in the company bank account. Investors can then choose to reinvest their dividend back in the company, use it to invest in another stock, or spend it.

Dividends are not tax deductible for the company, so they are paid in after tax dollars. Also, investors pay either ordinary income tax or a preferential tax rate for qualified dividends. So, in essence, the method of returning profits to shareholders via the payment of dividends is double taxed, once at the corporate level, once at the shareholder level.

What does it Mean for the Shareholder?

What is the net effect then to the shareholder? Say a company is worth 100 dollars, and an investor owns 10% of the company with 10 shares. If the company pays 0.10 dollars per share in a dividend, he now has 1 dollar in cash and a 10% stake in a company now worth 90 dollars. Right back to net zero, right? Wrong, he now must pay income tax on that dividend. To get his 1 dollar back, 20 cents go to Uncle Sam (for example), leaving him with 80 cents. Now the investor has a 10% stake in 90 dollars, plus his 80 cents in cash, leaving him with 20 cents less in value than before.

Lastly, because the company now has less value because it just paid out cash, the share price will actually go down all else equal. So, on paper, the company should have just done nothing, and Investor A would have been better off…the investor should be angrily calling his CEO and Board of Directors!

Why do them at all?

Many large healthy companies refuse to, such as Berkshire Hathaway, Alphabet, and Amazon, to name a few. But the majority still do issue dividends regularly, why is that? A couple of reasons. One, investors mentally like being able to get some sort of cash return from their investment regardless of the financial logic. Two, dividends are not taxable for investments held in non-taxable accounts, so it is truly net zero for those investors. Three, some investors would rather have their money back than have it sit in the company bank account where they may have limited-to-no control over how the money is spent.

With that in mind, how does this differ from a stock buyback?

Stock Buybacks

The Basics

Stock buybacks, or share repurchases, occur when a company uses excess cash on hand to go into the market and purchase its own common stock. It then cancels the shares and therefore lowers the number of outstanding shares on the market. This also raises the earnings per share of the common stock as the number of shares decrease, but your net earnings have stayed the same.

Typically, the company announces the amount of money they are allocating towards the buyback and sometimes give a range of prices they will consider purchasing their shares at. This is key though, the announcement is an option to repurchase, not an obligation. 

What does it Mean for the Shareholder?

As a common stock investor in a company, the effect is demonstrated in the example below:

Investor A owns 10 shares of a company, which has 1,000 shares outstanding trading at 1 dollar per share. The company decides to buyback 100 shares because it has more cash than it knows what to do with. Before the repurchase, Investor A owns 10/1,000 shares or 1.0% of the company.

The company then executes the repurchase, but Investor A holds his shares. Say the company paid 1 dollar per share (the market price) for 100 shares, that’s now 100 dollars less money the company has. But there’s also 100 less shares outstanding. So now Investor A owns a company with less cash, but Investor A also owns now 10/900 = 1.11% now, up from 1.0% from before.

The net effect to Investor A is…nothing! All else equal, the stock buyback shifted a portion of the company’s capital to the investor. So going forward, Investor A has a bigger piece of the pie of the company, which is 100 dollars poorer. If the company continues its success, Investor A will be happy that buyback occurred! For investors who did sell their shares to the company, they get a fair price, pay their capital gains tax, and are done with the company.

What is the Effect on the Share Price?

In theory, and this is a common misconception, the share price will not increase assuming the company paid a price equal to its intrinsic value. There are less shares now, but the company just shelled out money for those stocks, thus eroding its value. The only way the share price increases due to a buyback is if, long-term, the company bought them at discount. 

It’s important to note, the emotional side of investing can sometimes cause a price increase with an announced buyback. An investor might think, “If the company is buying back shares, it must be undervalued and my model is wrong, let’s raise my intrinsic value and buy more shares.” This causes the price to increase in the short term, but in the long run the price will revert back to its real intrinsic value. 

Why are they so Popular?

Now, why are corporations in recent years shifting from dividends to buying back stocks? Remember the absolute beating Investor A took from Uncle Sam when he got his dividend? Well, that won’t happen here. Why is that?

For Investor A who didn’t sell his shares back to the company, what actually happened? Nothing, as far as the IRS is concerned. Meaning the company was able to return money to the shareholders without having a tax leakage. The only person paying tax is the investor who sold his stock back and had to pay capital gains.

There are a couple of other reasons, some I mentioned above. 

  • Earnings per share will increase in future quarters, which can have benefits to executives whose performance metrics may be tied to earnings per share. 
  • If a company buys back stock, it no longer needs to pay dividends on those shares. If a company wants to shift its capital structure and lower its dividends paid, it could be a good investment to buy back shares.
  • Speaking of investing… another reason is, well, the shares were a good investment! Remember how I said it was net zero above for our Investor A? Well, it is actually not net zero for Investor A if the shares were repurchased at a discount to their fair value. In that case, the company was able to cancel more shares than it should have, which is a wise investment for the company and therefore Investor A who was able to essentially buy out his partners at a discount. Warren Buffett is very notable in his propensity to buy back Berkshire stock whenever he deems it undervalued.
  • Finally, investors may get annoyed seeing the company sitting on a pile of cash and the CEO does not know what to do with it. And by “doesn’t know what to do with it”, it means any new projects or investments do not exceed the company’s cost of capital. So instead, they just return it to the shareholders via a stock repurchase.

So why the Hate with Buybacks

There are a few reasons why politicians and the talking heads in the media decry stock repurchases as the worst thing since the designated hitter:

  • They think they are avoiding taxes that would have normally been paid via dividends. This is why congress and President Biden have been pushing for a flat tax on share repurchases.
  • Some companies have been reckless with stock buybacks and later require bailouts because of a lack of cash on hand. Examples are certain airlines after COVID, banks in 2008, etc.
  • If a company thinks their share price is incredibly undervalued, they may actually issue debt specifically to buy back their own shares. While in cold hard numbers this makes sense if they share price is truly undervalued, it is much more risky than using cash on hand. Long term though, it could provide extreme shareholder value if executed correctly. 
  • Companies could have reinvested that money in the company by paying employees more or investing in things like R&D, nicer facilities, etc. which may pay dividends in the future (pun intended).

Bottom Line

Stock repurchases have some pretty serious misconceptions out there. At the end of the day, it is a tax advantageous method to allocate capital to shareholders rather than back into the business. This, along with some other benefits, such as increased earnings per share and the company potentially snagging its stock at a discount. 

At the end of the day, as an investor, you must trust your CEO and Board of Directors with how they allocate capital. You have the power to invest in these companies, so choose to invest in ones that allocate capital the way you want it allocated. At the end of the day, that’s all you can do as an investor. Think your CEO is getting out of hand with the share repurchases, time to sell!

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