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In his article here, Roger Ehrenberg laments about the shortsightedness of management in its use of stock buybacks in lieu of dividends to return excess capital to shareholders. The comments that ensued were far and away in favor of Ehrenberg's primary arguments namely:

  • Corporations "do a terrible job timing their stock repurchases";
  • Buybacks are used "to mitigate the dilutive impact of option exercises" by management;
  • Buybacks are better because dividends "are perceived as a negative sign by Wall Street, indicating that there aren’t sufficiently important value-creating opportunities for investing firm capital."

Setting aside whether I agree with all of these oft-stated suppositions (I do not), the general impression the reader is left with is that buybacks only benefit management and those shareholders that sell while the remaining shareholders are simply left "holding the bag". But is this true? For dividend-paying stocks in particular, do buybacks provide any tangible benefit to the remaining shareholders?

To examine this, let's say Company X has a $1,000,000 market value and 50,000 shares outstanding. This implies a $20 market price per share. The company is currently paying a dividend of $40,000 per annum resulting in a 4% current yield and a dividend per share per annum of $0.80. The dividend has been increasing at 5% per annum and is expected to continue this level of increase for the foreseeable future.

Company X has accumulated $100,000 in excess cash and has found no suitable investment for the money so it decides to return the money to shareholders. The company rules out a regular dividend increase because, unfortunately this raises the market's expectation of maintaining the increased dividend and, as this extra $100,000 did not arise from a permanent improvement in operations, the company does not believe such a permanently increased dividend would be sustainable (unlike some of its peers, it does not like to deceive its shareholders). The remaining options are therefore to declare a $2.00 per share special dividend or buy back 5,000 shares of stock. This company is even more special though...it decides to put this choice to a shareholder vote!

Linda owns 100 shares of Company X in an IRA. Linda is satisfied with the 4% current dividend, 5% growth rate and, after some research remains confident about Company X's future. In preparing to vote, she begins to analyze the alternatives. With a special dividend she would receive $200 and continue to get the same expected dividend going forward...that's simple. But, what about a buyback? Will she get any benefit if that happens? Well, regardless of how the vote goes, the company is going to continue to pay the current $40,000 per annum regular dividend with the expectation of 5% annual increases, but wait...if the company buys back 5,000 shares, that $40,000 dividend will be spread over 45,000 instead of 50,000 shares. That means the dividend per share will increase even if nothing changes from what Linda expects....maybe she had better do a spreadsheet:

Option A

Special Dividend

Dividend

Total

Dividend

Linda's

Linda's

Year

Amount ($)

Shares

per Share ($)

Shares

Cash Flow ($)

0

100,000

50,000

2.00

100

200.00

1

40,000

50,000

0.80

100

80.00

2

42,000

50,000

0.84

100

84.00

3

44,100

50,000

0.88

100

88.20

4

46,305

50,000

0.93

100

92.61

5

48,620

50,000

0.97

100

97.24

6

51,051

50,000

1.02

100

102.10

7

53,604

50,000

1.07

100

107.21

8

56,284

50,000

1.13

100

112.57

9

59,098

50,000

1.18

100

118.20

10

62,053

50,000

1.24

100

124.11

11

65,156

50,000

1.30

100

130.31

12

68,414

50,000

1.37

100

136.83

13

71,834

50,000

1.44

100

143.67

14

75,426

50,000

1.51

100

150.85

15

79,197

50,000

1.58

100

158.39

Option B

Stock Buyback

Dividend

Total

Dividend

Linda's

Linda's

Year

Amount ($)

Shares

per Share ($)

Shares

Cash Flow ($)

0

-

45,000

-

100

-

1

40,000

45,000

0.89

100

88.89

2

42,000

45,000

0.93

100

93.33

3

44,100

45,000

0.98

100

98.00

4

46,305

45,000

1.03

100

102.90

5

48,620

45,000

1.08

100

108.05

6

51,051

45,000

1.13

100

113.45

7

53,604

45,000

1.19

100

119.12

8

56,284

45,000

1.25

100

125.08

9

59,098

45,000

1.31

100

131.33

10

62,053

45,000

1.38

100

137.90

11

65,156

45,000

1.45

100

144.79

12

68,414

45,000

1.52

100

152.03

13

71,834

45,000

1.60

100

159.63

14

75,426

45,000

1.68

100

167.61

15

79,197

45,000

1.76

100

175.99

Option B less

Simple

Extra Div

Year

Option A

YOC

Growth

0

(200.00)

1

8.89

4.44%

2

9.33

4.67%

5.00%

3

9.80

4.90%

5.00%

4

10.29

5.15%

5.00%

5

10.80

5.40%

5.00%

6

11.34

5.67%

5.00%

7

11.91

5.96%

5.00%

8

12.51

6.25%

5.00%

9

13.13

6.57%

5.00%

10

13.79

6.89%

5.00%

11

14.48

7.24%

5.00%

12

15.20

7.60%

5.00%

13

15.96

7.98%

5.00%

14

16.76

8.38%

5.00%

15

17.60

8.80%

5.00%

Interesting...if the buyback prevails, there will be no $200 special dividend, but, instead, in the first year, Linda will get an extra $8.89 in dividends. That's a 4.44% return on the foregone special dividend...11% better than the 4% return she is getting on the stock itself! This differential grows at the same expected 5% per year just like the dividend on the underlying stock. If Linda was happy with a 4% return and 5% expected growth, she should certainly be happier with a 4.44% return with the same 5% expected growth!

Wait, maybe there is another, better alternative investment for the special dividend. Well, if there is, shouldn't she sell all her stock and move it into the new investment because by definition, if it is better for the $200 it is better for the whole enchilada, right?

Well, how about if the stock doesn't perform the way Linda expects? Linda thinks about this but figures out she runs the same risk either way...the special dividend or buyback choice itself has no effect on a company's future underlying performance....it will be the same regardless. The only point where this relative benefit disappears is if Company X stops paying a dividend entirely but the same risk exists if she reinvests the $200 special dividend in Company Y and Company Y stops paying its dividend. And she already decided she was happy with Company X, didn't she? Linda votes for the buyback.

Conclusion: Buybacks reduce the number of shares outstanding. If the number of outstanding shares are reduced, any dividend will be spread over fewer shares resulting in an increase in the dividend per share (absent a change in the amount of the dividend itself). This is independent of what happens to the price of the stock after the buyback. The only time this effect will be lost is if the company suspends its dividend entirely but this same risk exists if a special dividend is reinvested in another company that could also suspend its dividend. As a result, there is an ongoing interrelationship between buybacks and dividends. Buybacks independently increase dividends per share and, therefore, benefit dividend investors.

Source: Dividends And Stock Buybacks: Mutually Exclusive Or Interrelated?