I Don’t Have the Same Feelings about Share Buybacks as I do Dividends

It is no surprise to anyone that reads the blog regularly that I really like consistent dividend paying stocks and then to get them “cheap” when compared to their value is just the icing on the cake.  I get an income stream and growth on my assets? Score.  However, there is another way corporations reward long term investors; it is known as Share Buyback programs.

What is a Share Buyback or Repurchase Program?

A share buyback or repurchase program is an acknowledgment from a public corporation that it will be buying outstanding shares with the intent of usually canceling the stock/making them treasury stock.  Since the earnings are kept constant and the shares outstanding are reduced the expectation is to increase some key metrics when it comes to the underlying equity.

How Investment Ratio’s Change after a Share Repurchase Program is initiated

Investopedia provides a pretty detailed example:

…buybacks reduce the assets on the balance sheet (remember cash is an asset). As a result, return on assets (ROA) actually increases because assets are reduced; return on equity (ROE) increases because there is less outstanding equity. In general, the market views higher ROA and ROE as positives.

Suppose a company repurchases one million shares at $15 per share for a total cash outlay of $15 million. Below are the components of the ROA and earnings per share (EPS) calculations and how they change as a result of the buyback.

As you can see, the company’s cash hoard has been reduced from $20 million to $5 million. Because cash is an asset, this will lower the total assets of the company from $50 million to $35 million. This then leads to an increase in its ROA, even though earnings have not changed. Prior to the buyback, its ROA was 4% ($2 million/$50 million) but after the repurchase, ROA increases to 5.71% ($2 million/$35 million). A similar effect can be seen in the EPS number, which increases from 20 cents ($2 million/10 million shares) to 22 cents ($2 million/9 million shares).

The buyback also helps to improve the company’s price-earnings ratio (P/E). The P/E ratio is one of the most well-known and often-used measures of value. At the risk of oversimplification, when it comes to the P/E ratio, the market often thinks lower is better. Therefore, if we assume that the shares remain at $15, the P/E ratio before the buyback is 75 ($15/20 cents); after the buyback, the P/E decreases to 68 ($15/22 cents) due to the reduction in outstanding shares. In other words, fewer shares + same earnings = higher EPS!

Want even more of a reason why buybacks are so great? No taxable event to shareholders.  When a dividend is paid out to me I have to pay taxes on it if it is held in a non-qualified account.  Not true with a buyback.

I could easily make the argument that this tax law is in place to prevent the hell that would occur for the IRS in trying to tax people when a company buys back $100,000,000 of its own stock.

So financial ratios get better and I don’t have a tax bill, why do I like dividends better?

Why I prefer Consistent Dividend Paying Stocks Rather than Company with a Share Repurchase Program?

Many people who talk about the subject bring up the fact that corporations often get blinded by their own success and end up buying too high.  For example, if a company has increased their profit and thus free cash flow, then they announce a stock repurchase program – isn’t it possible that the stock price has already been driven up? As such maybe they are buying too high.  I am sure there is plenty empirical data to support both sides of that argument so I don’t really rely on it too much.

The reason I like consistent dividend payers rather than investing in share buy backs has to do with my goal associated with my Dividend Portfolio.

I prefer the Increasing Income from Consistent Dividend Payers

My main goal for my dividend portfolio is to build a stream of income (consistent dividend payers) that keeps up with inflation (increasing consistent dividend payers – Dividend Champion list).  In doing so I try to find undervalued stocks so that I am buying that stream as inexpensively as possible.  A share buyback program in it of itself does not advance this goal as I would have to sell my principal in order to realize the benefits rather than just turning off the dividend reinvestment.

I Prefer the Stability Associated with Dividends

Just because a company announces a share repurchase program doesn’t mean the outstanding shares will decrease by that amount.  For example another great company I own is Aflac (AFL).  In August in 2010 there was an announcement that,

Aflac Incorporated (NYSE: AFL) approved a 7.1% increase in the quarterly cash dividend, effective with the fourth quarter payment. The fourth quarter dividend of $.30 per share is payable on December 1, 2010, to shareholders of record at the close of business on November 17, 2010.

The company also announced today its intent to resume share repurchase activities. Since first initiating a share repurchase program in 1994, the company has purchased 232.1 million shares. Aflac suspended its share repurchase program in the fourth quarter of 2008, following the onset of the financial crisis. At the end of June 2010, the company had 32.4 million shares available for repurchase under authorizations from the board of directors.

3 Years later if we look at the outstanding share it still hasn’t been decreased by 32.4 Million shares:

AFL Share Repurchase ChartMore than 3 years later the outstanding shares are only 7million less.  While this is still fantastic it is a far cry from the goal mentioned in press release above.

Increasing Consistent Dividend Payers with a Share Repurchase Program

I think I get the best of both worlds when a stock I have already bought announces a share repurchase program.  For example, I currently own a little under 21 shares in Chubb (CB).  I haven’t actively purchased a share since 9/23/2011 all shares purchased since that date were just dividend reinvestments.  In early 2013 Chubb announced,

Warren, N.J.,January 31, 2013 – The Board of Directors of The Chubb Corporation [NYSE: CB] today authorized a new share repurchase program for up to $1.3 billion of the Corporation’s common stock. Purchases may be made from time to time in the open market or in privately negotiated transactions. This new program replaces the program approved by the Board on January 26, 2012 that provided for the repurchase of up to $1.2 billion of the Corporation’s common stock. Approximately $979 million of the Corporation’s common stock was repurchased under that program.

Capital management continues to be a key focus of Chubb. This new share repurchase program that we are announcing today reflects Chubb’s strong financial condition as well as an ongoing commitment to the importance of our capital management strategy. Although the program has no expiration date, we currently intend on completing it by the end of January 2014, subject to market conditions and other factors,” said John D. Finnegan, Chairman, President and Chief Executive Officer.

So that means, if everything stays the same (which it won’t) my shares are becoming more valuable while my income objective is met.  That will be a huge win over the long term which is how long I plan on holding my small position. How long? who knows? Maybe until CB gets kicked off the Dividend Champion list or something changes dramatically in how the executives operate the business.

4 Responses to I Don’t Have the Same Feelings about Share Buybacks as I do Dividends

  1. I much prefer a dividend in my hand rather than a share buyback. Too often I’ve seen companies ramping up their buyback program at what ended up being the worst time. If they consistently DCA then I think it’s a bit better. Plus as you mentioned the objective is to receive a rising dividend stream every year. An increase in value of the shares I own means little when I’m owning them for the dividend stream.

    • It almost makes sense that they buy at a bad time…it is likely they are buying shares at the exact moment the market has already run up the share price because of a good quarter or year.

  2. MJTM,

    I am also in the boat of rather having the dividend to decide myself what to do with it. Its almost like taxes, would you rather decide what to do with the money or have the government do it for you? Extreme example, but same principal, only hopefully the company you own is making better decisions than the gov and not as leveraged! I do think having a long-term buyback plan can be a positive thing. Apple for example is executing, although borrowing some for their buyback. Normally I would not support that, but the cash outside of the country issue I believe is a good excuse to borrow with all-time low rates.

    -RBD

  3. There are companies that are especially suited to buybacks, whereby the shareholder gets ahead. First, you need to have the management that will actually retire the shares, and not award the shares out the back door. Also, companies with the highest quality earnings are very good candidates. Think consumer staples or other firms with some sort of moat combined with a low valuation.

    Companies such as PM, MO and XOM have demonstrated that share buybacks increase wealth. For example, in the past 5 years PM has retired 35% of its outstanding shares. During this time, PM has always been undervalued compared to other quality consumer staples companies so the buybacks were beneficial.

    There are always poor examples. IBM in the past overpaid for its share buybacks, and this caused the shareholders to achieve low returns. Right now, you can make a case that IBM is attractive because the valuation is much lower and the company is continuing to buy back shares.

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