Buybacks usually beat dividends

The objective of listed companies is to maximize shareholder value. A business creates shareholder value when the capital invested in it generates more than the investors' required return. The present value of a share is determined by the estimated amount of cash that the company will be able to pay out to its shareholders during its lifetime.

Cash can be returned to shareholders in the form of dividends, share buybacks, or by selling the company for cash.

This method of returning cash through transactions has once again sparked a debate in Finland. Without going into further detail, there have even been calls for a ban on the repurchase of own shares. However, share buybacks are a very convenient and efficient way to return capital to owners. There are many misconceptions about share repurchases that I will try to correct in this article.

First, it is important to understand that a company's value is created through its operations. Dividends and share buybacks reduce a company's ability to invest in its business or make acquisitions. Therefore, the distribution of capital to shareholders should be viewed first and foremost in relation to the potential return on capital in the hands of management. If there are no attractive investment opportunities, then it is time to return some capital to owners. A significant proportion of listed companies in Finland distribute more than half of their profits as dividends.

When a company pays dividends, it distributes cash from the company. The owners' wealth does not change because they already own this money as part of the cash resources of the company. For example, if a EUR 100 share representing a stake in a real company pays a dividend of EUR 10, the investor will have a share worth EUR 90 in their portfolio and EUR 10 in cash (minus taxes) in hand after the dividend.

Dividends are a bit like exchanging a 20-euro note for coins. You seem to have more money in your pocket, but you still have the same 20 euros you had before the exchange.

In principle, the repurchase of own shares (and cancellation after purchase) is a similar transfer of money into the owner's pocket. If a company with a share price of EUR 100 starts a buyback program for EUR 10 per share, the investor's wealth will still be EUR 100 at the end. The value of a share will fall to EUR 90 as the sellers of the shares get their cash, but the number of shares will also fall by 10%. As the number of shares decreases, the remaining owners' stake in the company increases accordingly.

Buybacks do not destroy shareholder value

Share repurchases do not, in and of themselves, destroy or enhance shareholder value. They transfer it. If a share can be bought at a price below its fair value (which is often difficult to determine precisely), the remaining owners share the benefit. If a share is bought at too high a price, the sellers benefit. Finns are often resentful of Nokia's share buybacks in the early 2000s. But is it more the fault of the owners who did not take advantage of the company's buyback program by selling their own shares? In the end, it is always the owners themselves looking in the mirror at their own failure.

Advantages of share buybacks

The advantage of a share buyback is that it is up to the investor to decide when to pay their taxes. Dividends simply flow into the bank account after the general meeting, and the individual owner has limited influence over the decision. In contrast, when the company buys back its own shares, the owner can decide when they want to sell their shares and thus trigger a potential capital gains tax.

The return on stocks is often measured as total return, which includes the increase in the value of the stock plus dividends. In practice, dividend investors rarely get this total return because they pay taxes on dividends immediately, almost never reinvest all dividends back into the stock, and if they do, they have to pay trading costs. Of course, not all owners can receive the total return of a share, because for every buyer of a share there must be a seller among the owners.

Motivations behind share buybacks

Unfortunately, there are sometimes ulterior motives for repurchasing shares that are not in the best interests of the owners. Buybacks are the best way to allocate capital if the stock is undervalued. “No alternative action can benefit shareholders as surely as repurchases,” Warren Buffett wrote in a 1984 letter to shareholders. Another, less obvious but equally important message of share buybacks is that management is thinking about shareholder value, not maximizing the size of the company. After all, it's money taken away from investments that could grow the company no matter the cost (growth can also destroy shareholder value).

Companies that buy back their own shares can be roughly divided into three schools of thought:

i) “School of fair value” = the market is always right, so the company repurchases its own shares at a steady pace regardless of the price (e.g. Sampo, Nordea, Murphy, Travelers, Monster Beverage).

ii) “School of intrinsic value” = aiming to buy shares when the company is undervalued by the market (e.g. Berkshire Hathaway).

iii) “School of cunning foxes” = repurchasing own shares to reduce the dilution effect of share bonuses or to try to improve EPS (more common in the US). However, an improvement in earnings per share is not a sure thing. If the stock’s earnings yield (inverse P/E ratio) is lower than the interest income on the capital, EPS will in fact decline despite the reduction in the number of shares.

 It’s vital for investors to take a look at their own companies involved in buyback programs and assess which school of thought the management, board of directors, and main owners who ultimately approve the decisions actually belong to.