There has been a lot of discussion lately regarding stock buybacks and dividends. Recent articles have discussed potential benefits of buybacks, such as higher EPS and deferral of taxes, as well as concerns about poor execution of buybacks by management. Another article focused on when dividends are better than buybacks. I'm sure the dividend growth investor crowd is pretty familiar with the usual arguments, but being a person who likes to see some numbers, I decided to try modeling these scenarios to see what would happen.
A couple of disclosures are in order:
- Personally, I always prefer a special dividend to a buyback because I like to make the choice of whether to reinvest in the firm or not. Most of my funds are in IRAs, so taxes are not an issue for me. Regardless, I think I would still prefer the choice, even if it means paying dividend taxes now versus capital gains taxes later.
- There is no simple way to model stock pricing, so I created two models that use the Price/Earnings (P/E) ratio. Obviously we cannot predict what really happens after a buyback, or a dividend for that matter. I assumed comparable valuation methodologies regardless of the method of cash disbursement by the firm.
- I am not an accountant, but I believe my balance sheet arithmetic and methodology is accurate.
- Some of the discussion in previous articles focused on the destruction of value when firms repurchase their stock at high prices. I sought to quantify this and find out what value is lost, both in terms of book value and market value, which are two different things.
For these models, I created a hypothetical firm, Buyback Inc. that has 10,000 shares outstanding with a current price of $90/share. The firm earns $100,000 annually, so EPS is $10/share, and the P/E is 9. I created a simplified balance sheet, shown below, with the firm having $1MM in stockholder equity for a book value of $100/share. Excess cash is considered to be cash above and beyond what is needed to run the firm; these funds are available for a special dividend or buyback.
So, we have a company that is undervalued based on book value and that has cash available for a dividend or buyback. Let's look at what may happen to both the book and market values under different options. To keep things simple, these scenarios assume that the shareholder has one share at the current price, and gain/loss is relative to that price.
Special Dividend Scenario at $90 per Share
I began with my preferred option, a special dividend. Feeling generous, the firm opts to give $90,000 ($9/share) back to shareholders. Sweet! But how does this impact the balance sheet and my overall total value?
$90,000 of excess cash is distributed, which is removed from assets and from shareholder equity. The balance sheet must balance! EPS is still $10, as earnings and outstanding shares are unaffected. The book value per share is reduced by $9. Furthermore, when the stock goes ex-dividend, the market price of the stock is also reduced by $9. The shareholder has $9 in his pocket, but unless the stock price goes back up, he has not gained in total return. Here's where I created two valuation models to simulate potential outcomes for the stock price.
In the P/E model, I assumed that the market price is a function of earnings and P/E, therefore regardless of this dividend, the stock's price would return to $90, as earnings and P/E were constant. Assuming the investor reinvested the dividend at the $81 ex-div price, he would now have 1.111 shares for a total value of $100, and 11% gain. Note: if the investor pocketed the dividend, the total value would be $99, for a 10% gain, which is what we would expect from a 10% dividend.
The P/Ex + Cash model factors out the excess cash from the market price first, then determines the P/E for the underlying business. Think of a firm like Apple (AAPL) that has $100/share in cash on its books. The current stock price of $600 includes $100 in cash. So from one point of view, the company's business (future cash flows) is worth $500/share. The P/E will obviously be lower, which is one reason I like this stock as a value play despite its high price. For Buyback Inc., if we remove the $20 in cash, the business is worth $70/share for a P/E of 7. After the dividend, the stock would be priced at $81 ($70 + $11 in cash per share), but the shareholder has 1.111 shares, so his total value is still $90. There was no gain under this pricing method, as is the case with normal dividends. Until the price goes back up, total return has not increased.
Special Dividend Results:
- Book value decreases by $9
- Total shareholder value could be between 0% to 11% gain
- Price impacts the yield that the shareholder receives. Assuming the P/E valuation model, the investor gains that amount.
Buyback at $90 per Share
Now let's look at the same situation, but with a $90,000 buyback instead of a special dividend. As seen in the chart above, at $90, the firm can repurchase 1,000 (10%) of its shares. Assets are again reduced to $910,000, as cash was spent and shares held as treasury count as negative equity. Treasury shares are not counted as part of outstanding shares. I am not going to get into the discussion of buying back shares for the purpose of giving out bonuses. I am assuming that if the firm did not repurchase shares for this purpose, it would issue new ones and dilute shareholder equity, so either way THIS buyback reduces shares. The buyback results in an increase in book value, thus reinforcing the argument that buybacks are beneficial when the price is below book value. But, does this translate to higher market value?
Using the same two P/E models as before, we again notice that under the P/Ex model, which separates out cash first, the transaction is a wash. This happens because nothing changed in the underlying business, and the cash spent cancels out the per-share increases. Under the normal P/E model, we see the same 11% gain as with the dividend scenario. To those who like arguing that buybacks and reinvested dividends are essentially the same thing, "you're welcome".
Buyback @ $90 Results:
- Book value increased by 1.11%. Not very significant, but it validates the buyback adding value.
- Total return value again ranged from no increase to 11%.
Buyback at $120 per Share
Now let's examine a buyback when the stock price is above book value. As expected, the firm repurchases fewer shares with its $90,000. The result is a decline in book value from $100 to $98.38. In this respect, shareholder value has indeed been "destroyed", but what about the market value?
All else being equal, the 7.5% reduction in shares causes EPS to increase by 8.1%. Assuming the stock maintains its PE of 12 ($120 original price / $10 EPS), the stock price should now be at $129.73, an 8% increase. As usual, the P/Ex model is a wash.
Buyback @ $120 Results:
- Book value declined, reinforcing the argument that buying back stock above book value lowers value. More specifically, it lowers book value.
- Market value could still increase, as EPS will go up because there are fewer outstanding shares. However, the firm paid 9% of its assets for an 8.1% price increase, so in that sense, the firm overpaid for the gain.
Buyback at $180 per Share
Finally, I decided to try a situation where the stock had a much higher valuation. Again, book value is lost. The firm spent 9% of assets and the net impact on book value was a decrease of 4.2%. At higher prices, this book value loss grows (e.g. At $360, book value fell 6.7% to $93.33). While this looks bad, keep in mind that in the dividend scenario, book value fell the entire $9/share, but we potentially gained the full $9 in market value.
In this scenario, assuming constant P/E, the stock gains up to 5% due to higher EPS. Paying the higher price per share resulted in lower total return benefit to shareholders. The gain diminishes as the buyback price increases. While the dividend scenario seems preferable, keep in mind that at $180/share, a $9 dividend is just a 5% yield, so again, the situations are aligned. The big difference occurs if the investor takes the dividend as cash (no reinvestment), and then the stock price declines because it is overvalued. Again, this choice can only happen if a dividend is paid instead of a buyback occurring.
Buyback @ $180 Results:
- Book value and the potential market value gain are even lower than in other buyback scenarios, but it is a still a net positive from a market valuation standpoint.
Based on these models, I reached the following conclusions:
- Book value declines if a firm repurchases shares at a market price above book value. Book value also declines after a dividend is paid. Neither necessarily has a negative impact on market price or the investor's total value. In fact, at worst, the impact appears to be neutral. Of course, if the price proceeds to fall by 25%, shareholders will wish that the company had kept that cash! Those who automatically reinvest their dividends may wish that they had kept it as cash too.
- The potential gain from a buyback diminishes as the buyback price increases. Likewise, the yield of a special dividend also decreases as the price increases.
- Repurchasing or reinvesting in a stock below book value has the greatest potential upside from a total return standpoint. Repurchasing below book value also raises the book value per share, which could help support the stock price. At some point, if the market price were far below book value, someone would likely take over the firm if for no other reason than to break it up and sell off the pieces for the higher value.
In terms of total return, there appears to be little difference whether the firm distributes the excess cash as a special dividend or via a buyback, excluding the tax and transactional considerations and assuming comparable pricing methodologies. Since investors may reinvest the funds to receive the same return that a buyback would yield, I still favor getting the dividend and having that choice. Book value will decline the most in the dividend scenario, but if stocks were priced based solely on book value, Altria (MO) would be at $1.82 and Kimberly-Clark (KMB) would be at $13.68 (Source: Yahoo Finance). Now, there are limits to this; negative book value is not typically held in high regard and could trigger debt covenants. Even at overvalued levels, buybacks lowered book value less than a dividend payment.
This helps to support my interest in stocks that balance dividends and buybacks, such as IBM (IBM), Philip Morris (PM), and Microsoft (MSFT). However, for the amount they are repurchasing, I'd prefer that they increase their dividend growth rates! This would satisfy the dividend investor's desire to receive more cash consistently from the firm. Assuming a valuation model based on the stock's yield, continued dividend increases should lead to steadily higher stock prices. The extra increases would need to be sustainable though. How this compares over time to receiving $9 at once or a buyback is a question that I leave for another day or another contributor.