Why Buybacks, Buyback Yield And Total Yield Are So Important When Stocks Are Falling

Summary

• Buybacks provide real value to shareholders. This article will explain the math of why that's so.
• I provide four examples of the returns for three theoretical companies: 100% buybacks, 100% dividends, and 50% buybacks/50% dividends paid out. The last example is buybacks when stocks fall.
• In every case, investors in the company which buys back shares, all other things equal, will outperform, in total return terms, investors in the company that only pays dividends.
• I also provide examples of real public companies that have large buyback companies, and why you should buy them now.
• This idea was discussed in more depth with members of my private investing community, Total Yield Value Guide. Get started today »

Why Buybacks and Buyback Yield Is So Important

I write articles about stocks that have large buyback programs. The buyback yield is the dollar amount of annual buyback dollars spent divided by the market value of the stock. This article will explain why buybacks and buyback yield are so important, especially now that stock prices are generally falling.

Often I get the complaint from readers that you can't spend buyback yield. You can only spend the dividend yield paid out. But the truth is the exact opposite. I will show you why.

Another complaint is the buybacks should be spent on dividends since it provides nothing to shareholders. So then why are so many companies spending large amounts on their buybacks? In fact, many companies that pay dividends have even larger buyback programs on top of their dividends. In this case, the total yield, buyback yield plus dividend yield, comes into play.

The reason is that buybacks provide higher total returns to shareholders. There's both a tax advantage element plus a capital gain element to this advantage. I will give you some examples of how the math works.

Examples of Buybacks versus Dividends

Let's create two companies, Company A, which pays out 100% of free cash flow in buybacks, and Company B, which pays out 100% of free cash flow in dividends. I will show that Company A always will produce a higher return for shareholders.

Now here are the assumptions that will not change. The market value of both companies is $10 billion. There are 1 million shares outstanding. Therefore, the starting price of the investment is $10 per share ($10,000 million divided by 1,000 million shares). In addition, both companies produce $500 million in free cash flow. Company A buys $500 of stock each year. Company B pays out $500 million in dividends. The tax rate on the dividends to investors in Company B is 25%.

Source: Hake

Company A. Here's what will happen to Company A investors over five years:

Source: Hake

Here's how to read this table. Year one the company is able to buy back 50 million shares (i.e. $500 million divided by $10 per share). That leaves 950 million shares outstanding. Since the market value stays level in this example, the new price per share must be $10.5263 per share. This is because at the end of the year the $10 billion market value divided by 950 million shares is equal to $10.5263 per share.

Now during Year 2, the stock price is higher at $10.5263, so the company can only buy back 47.5 million shares. As a result, there are now 902.5 million shares outstanding. That moves the stock price to $11.083 (i.e. $1 billion divided by 902.5 million).

And so forth, such that by the end of year 5 the stock price is now $12.9236 per share. That's a 29.236% gain over five years, or a CAGR (compounded annual growth rate) of 5.26% per year over five years.

Now note here. There are no taxes. The stock price has made this unrealized gain of 29.2% through tax-free compounding. Only if the investor sells, which is optional, will taxes be paid. (Also, the long-term rate is lower than the dividend income rate, but more on that below.)

Company B. Here's what will happen to Company B investors over five years:

Source: Hake

Each year, the investor collects $0.50 per share. But since he pays taxes on the dividends, the net return is 3.75% per year (you can use any tax rate you want here - the point is taxes must be paid on the dividend income).

So the stock price stays at $10 as well. Therefore the accumulated value is $11.875 over five years. This works out to a CAGR of 3.50% per year.

Therefore, you can see that Company A investors outperform Company B investors:

Source: Mark R. Hake, CFA

Company A investors will end up with $12.924 per share of accumulated value over five years, vs. $11.875 for 100% dividends. This is an outperformance of 10.5% on the original $10 investment per share by the investors in Company A.

What If A Company Pays Out 50% of FCF in Dividends and Buys Back Shares With the Remaining 50% of FCF?

We can easily model this out as well. Let's call this company Company C. It spends $250 million on buybacks and $250 million each year on dividends. Will investors in it still outperform the 100% dividend payout company?

The answer is yes. But not as much. Here is the model for Company C:

Source: Hake

From this table, you can see that the after-tax gain for the portion of the dividend paid out plus the gain in stock price from the buyback portion results in a stock price and cumulative after-tax dividends of $12.362 per share at the end of Year 5. In other words, it was a 23.62% gain over five years, and a CAGR of 4.33%.

Source: Hake

This is still a 4.87% higher ROI than the Company B investors who ended up with $11.875 per share in accumulated after-tax value at the end of year 5.

But it's less than the $12.9236 per share in accumulated value in Company A, or 29.25% of the accumulated value, and a CAGR of 5.26% per year.

What If Stock Prices Fall? Will Company A Outperform?

This is where things get complicated. Yes, in general, investors in Company A will outperform Company B. But it depends on how the stock falls, and of course, how far the stock falls.

The main reason is that investing in stocks that are falling in price, but the company is buying back shares, will lead to a larger buyback program. By the end of five years, all things being equal, the accumulated value will be higher.

Here's an example: Company A's stock falls 5% each year during Year 1 and Year 2. Then the price rises.

This shows that the price falls to $9.50 in Year 1, but the ending value is $10.5556 for Company A, since it has bought back more 2.63 million more shares at the $9.50 rate (i.e. 52.63 million shares less 50 million shares in the case where the price was stable at $10 per share). In Year 2 the price falls 5% from $10.5556 to $10.028, so the buyback amount bought back was 49.86 million shares. However, in Years 3 through 5, the stock price rises and the amount of shares bought back is close to the number of shares in the original example.

As a result, the company is able to buy back 229.5 million shares over five years, vs. only 226.22 million in the original example. Therefore, the accumulated value is slightly higher, at $12.9954 per share, vs. $12.9236 in the case of 100% buybacks with a stable price.

However, this clearly outperforms the case where 100% of FCF is used for dividends:

Source: Hake

Now, let's be realistic. If the stock falls for five years straight, then the buybacks will take longer to work out on a positive basis vs. the case where the company just paid out 100% in dividends.

However, this brings up an additional benefit of buybacks: They tend to ameliorate the downturn in a stock price. The pressure of having a constant buyer in the market for a stock effectively tends to act as a support base absorbing constant sellers.

In addition, there are other benefits to buybacks vs. otherwise. First, the investors' stake in stocks with buybacks increases. This benefits the investor in case of future dividends, spin-offs or even the sale of the company. That's one reason why Buffett tends to invest in companies with large buyback programs.

Second, the dividends per share tend to rise faster at companies with buybacks. This is because even with a stable dividend cost over time, the lower pool of shares for the dividends increases the dividend per share. I have shown this effect in many of the stocks in my articles. Third, there's a comparable effect on earnings per share and tangible book value per share, but these are not as practical as the increase in dividends per share.

Examples of Stocks With Large Buyback Programs

Below is a list of stocks with large buyback programs and which also pay out a large dividend yield. This provides the best of both worlds: High dividend yield and high buyback yield. Therefore, they have high total yields:

Source: Hake

I have written about a number of these stocks in prior articles. For example, in my article on ConocoPhillips (COP), I point out that the company has announced a $25 billion buyback program. Its market value is only $53 billion or so. I estimate that the company will do at least $3 billion per year, but it could be much higher than that. COP has a 9% total yield.

Similarly, Wells Fargo (WFC) has a massive buyback program. I recently wrote about this in Seeking Alpha. Their buyback program last year was $24 billion. Its market value is $170 billion or so. That represents over 13% of its market value.

The same is true about Prudential Financial (PRU), and you can read about my recent assessment of their buyback program. PRU stock has a 7.7% buyback yield and a total yield of over 13%. My article on Medifast (MED) shows that the stock has a 5.5% dividend yield and a 5.5% buyback yield. Lastly, eBay (EBAY) has been spending more than $4.2 billion on buybacks, even though its market value is only $30 billion. I argue in my article on EBAY that the stock is significantly undervalued as a result.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Mad_Monk]

Dear Mr. Hake,

Good day to you sir.

I have three primary quibbles with buy backs.

First, they produce nothing (such as increased sales) and even if purchased with Free Cash Flow, may be better deployed for things like debt reduction or R & D, COP is an example of debt reduction and MMM is an example of R & D.

(I am long both COP & MMM.)

Second, that unrealized gain has little benefit for most individual investors. Sure, it looks great to see Company A's share price go up. But to benefit I have to sell and then based on the number of shares the gain is small and taxes kick in. Taxes always kick in.

Third, with respect, the application of taxes to only dividends is biased toward your conclusion. 100% true we do not have to sell. But, without dividends unrealized capital gains are dead money. Additionally, most of us have to pay a percentage of the sale price to the broker. Dividends seldom incur this fee.

Company A in your example has a capital gain of $2.9236. Using your 25% tax and 1% commission that reduces the benefit of those gains to $2.634 Still better than dividends. over five years. ROI on an annual basis for buy backs average is 0.5847. Still better than the ROI for Company B at 0.3750 (even if this value would most often increase every year.)

0.5847 less taxes and commission (call it 25% and 1%) is 0.1520 reducing my gains to 0.4326. Still better than Company B. But, add a modest 2% annual increase to the dividend over time and the dividend will provide a better return than buy backs. As-an-aside, there are a lot of companies with a history of increasing their dividends for decades but there is no such history for buy backs.

Post Tax Gain Price + Cum Div
$0.3750 $10.3750
$0.3825 $10.3825
$0.3902 $10.3902
$0.3980 $10.3980
$0.4059 $10.4059
$0.4140 $10.4140
$0.4223 $10.4223
$0.4308 $10.4308
$0.4394 $10.4394
$0.4482 $10.4482

Factor in reinvesting those dividends until they need to be harvested and they have greater long-term benefit vs. buy backs.

Closing Remarks
A great article because it made me question my conclusions. Thank you. At least now, I can see some case specific on an individual firm's situation potential benefit to buy backs. Since you cited Mr. Buffet permit me to paraphrase him, my holding period is forever.

Cheers,

Mad Monk

[Dividend Ambassador]

Great article. I’ve been pounding the table on WFC and PRU as being exceptional bargains this past week. Article needs updating however. WFC is trading for $37 w a 5.5% yield. Market cap now only $152 Billion. $24 Billion would buy back 16% of the float at current price.

[grharbart201]

I tried to pay my bills with buyback money, and they would not take it. I am a numbers guy and I believe , in most cases , buybacks are stupid. At least for me. I understand all your math, but in the long run buybacks help management reach some goals I don't care about. Buffett says buybacks are good, but look at what he does, not says. Buffett wants them to borrow money to buyback shares so that when they get in trouble he has fewer shares to buy. I have watched many companies buy back shares and they got into serious financial crisis. In many cases they even borrowed money to buy back shares and lived to regret it. I could list a hundred real quickly, but just do your own research and it will be obvious . IBM is one example of a company that thought buying back shares was the best use of money... Really?

[zeppelinhellas]

Thanks for the information

[Incomeiam]

Rds.b is currently buying an enormous amount of its shares.

[BM Cashflow Detective]

From my point of view, this topic is simple. I like dividends and I also like share buy-backs that are tax-efficient below fair value. If the shares are purchased by the respective company below the fair value, the difference creates additional value up to the fair value, tax-free. The total number of tradable shares is reduced. This increases the value of my shares and I get more dividends per share. This is an irrefutable causal link. In my opinion, fantastic financial engineering. I don't see it as a problem that these effects often have a very late effect on the share price. I do not need to be immediately confirmed by other market participants in this matter. The fact that share buybacks are often done incorrectly is very unfortunate. This destroy the shareholders' capital. Firms and CEOs who buying shares above the fair value destroy the difference in capital that is above fair value. This is also a causal link. It is not the job of the CEOs to do that and the job of the supervisory board is to prevent it. Which often doesn't happen. But if stock buybacks are carried out correctly, it is always in the interests of the shareholders.
That's why the article is an interesting and additional confirmation for me.

[Matt GV]

Mark, interesting article, thanks. It seems from your other publications at SA that you are not a fan of ETF's now that retail investors can trade stocks commission free. That aside, would you care to comment on the methodology of the ETF SYLD, which selects constituents based on total shareholder yield?

[Mark Hake]

I will have to look at in more detail.

[User 49413349]

Here is an article showing the real truth about buybacks and how companies seem to buy back the most at the top in boom periods and much less in downturns when they should have bought back shares. hbr.org/...

[Mad_Monk]

@Cedrick

Thank you for the link. Great article.

[User 49413349]

Your analysis shows nothing. You can make more money with dividends and more money with buybacks depending on how the market moves. However I would take a dividend over a buyback any day. There are so many examples where companies buy back shares at or near all time highs completely destroying shareholder values. I even think I have seen statistics showing that this is exactly what the majority of companies does. Because near all time high they often have more money then they know how to spend so they spend them on buybacks, because it will increase EPS and stock price something that often triggers larger bonuses for the CEO and CFO. And when the downturn comes they have less cash need to take up more debt and the stock buybacks has done nothing other then destroying shareholder value. A dividend is in general much better, you can then take your dividend and invest it somewhere else and get a higher return. Look at the banking industry before the financial crisis. You will see the stock buybacks where the largest leading up to the crash, completely destroying value. Look at oil stocks, same thing there. Now XOM is at a 15 year low, even though they have spent billions on buybacks over the years. You could argue it would maybe be at 20 year low without buybacks, but who cares? A dividend would have been much better reinvested in another stock sector. Buybacks are in most cases nearly waste of money compared to paying it as dividends to the stock holders.

[Mark Hake]

Actually XOM has dramatically reduced its buybacks in the last four years. That's part of the reason why XOM has slumped . Here is an article I wrote about this: seekingalpha.com/...
By contrast COP has a buyback program for almost half its market value and has done much better: seekingalpha.com/...
If you read any of my articles you will see that I focus in total yield since so many companies like Apple (AAPL) which continue to buyback shares, even as their shares rise, tend to do quite well compared to those companies that don't: seekingalpha.com/...

[User 49413349]

@Mark Hake CFA Obviously XOM has dramatically reduced its buybacks the last four years. If you had followed the oil and gas sector you would know it topped out about 4-5 years ago. That is my point, they buyback the most at or near the top and then reduces the buyback as the stock falls, when everyone knows the smart move would be the opposite.

In the short term buybacks can be good but in the long term it is a horrible use of shareholders money, long term it destroys more value then it creates. There are tons of articles and research on this. Just look at all oil companies now, and all bank stocks right before the financial crisis a decade ago.

[Mark Hake]

I showed you mathematically how buybacks create value. Your statement that buybacks have destroyed value goes against the math. The stock would be significantly lower if it had not done buybacks. The reason is it tangible book value per share and earnings per share and even the dividend per share would be much lower without the buybacks. If you want to make statements that have no underlying proof mathematically go ahead. I have made the intellectual case and theory behind buybacks.

[Bronco Fan]

Long term capital gains or qualified dividends...Depends on when you want to take the hit. Everyone's circumstance is different.

[tbonez]

thanks for spelling it out, it's amazing something so simple as buybacks is so controversial, though I'd add what buffet said about buying below intrinsic value, if you had 2 partners and you buy 1 out at 80%, you'd do it, if they said 120% you'd say no way; if your timeframe is short, the temptation is to take the money( dividends) and run, in the long term why the hell wouldn't you want to have a bigger slice of the pie, not give a piece to the government, and have the company internally reinvest the money at a higher rate especially with treasuries yielding less than 1% now; for those who say buybacks don't pay the bills, you can show the tax deferred compounding and the lower long term cap gains rate on share sales versus paying the marginal tax rate on dividends, then again if you need the money to pay the bills, it's probably not a good idea to be investing that money anyways, thanks for the article

[User 49413349]

@tbonez XOM have spent tens of billions of buybacks over the last 15 years. Today they stock price is even lower then it was 15 years ago. The buybacks did nothing the only return those people buying XOM 15 years ago have to show for are the dividends. I would guess that if you looked at any statistics you would see that in most cases stock buybacks was a waste of money compared to paying it as dividends.

[tbonez]

Thanks for your comment, I have no special insight into XOM, nor do I think buybacks are the only factor, I guess only thing I can say is You can't get blood out of a stone, if a company ain't doing well there's no money for anything, buybacks or dividends, reminds of buffetts famous 1977 article in fortune, he mentions electric utilities and at&t that issued shares to meet their 'promised' dividends, he said it was like something out of Alice in wonderland; it's like munger, let's invert; issue and dilute shares like crazy, then use the $ to issue special dividends to shareholders, and of course leave a little something for the government, where do I sign up. www.google.com/...

[azazel88888]

It’s only for c suite executives to get bonuses. Not a return to shareholders. They buy at ATH then the market tanks i.e. 12/2108 and they already spent all the buyback money before the downturn.

[xomstock]

You can’t buy groceries with a buyback.

[Mark Hake]

The whole point is that my analysis shows you make more money with buybacks. So even though some of the return is in unrealized gains you simply sell stock to buy your groceries. I really cant believe I have to point this out.

[It Is All About The Timing]

You sell the stock for a one time purchase of groceries where the dividend buys groceries forever.

[ilovestocks32567]

A dividend is no different than selling

A dividend comes out of the price of the stock and then you hope the price goes back up

A sale of stock does not drop the price of the stock. They both have the same net change on the value of your account.

[User 44808496]

Problem is that in many cases the buybacks just offset the new share grants to execs

[Mark Hake]

Two points here. Yes there is an anti-dilutive effect tobuybacks. In fact this is one of its benefits.butmost companies that are serious about buybacks buy back significantly more than the amount of shares issued from options, RSAs etc. And lastly dont forget that options, unless cashless, provide cash upon exercise to the company so that it can then buy back shares that it just issued. This in fact is how the Diluted EPS formula is calculated under GAAP.

[ilovestocks32567]

It seems like none of the banks are doing buybacks...They should, but the fall was so much I don’t think they were buying

[DJCO shareholder]

The banks are buying back shares. No body cares though (in the current environment). Wells bought back about 1.1m shares per day from 1/2/20-2/18/20. First link shows period end WFC common shares outstanding at 4134.4m. 10K has 2/18/2020 common shares outstanding at 4099.9m.

seekingalpha.com/...

seekingalpha.com/...

You can do the same with BAC. I think they were buying around 2m/day from 1/2/20-2/18/20.

[ilovestocks32567]

Thanks for the info

Thought it was only me buying these last few days lol

[Cliff Courson]

One caveat on the comparisons, to be more precise: The Author compares Company A vs Company B or C as a buyback entity vs paying out dividends, or a mix. Of important note, but not mentioned, is that these dividends being paid can be immediately reinvested (diversification) either into something else, saved up for later as cash, or used/spent as a cash flow to offset living expenses as needed or desired. If reinvested immediately, there should be some assumption this reinvestment would bear fruit. Some more than others. Alas, the flexibility of saving up the cash, to make a purchase during market duress or irrationality, cannot always be quantified, but can be qualified. What seems great last week, can be worse or better next week, and this financial flexibility of the paid out dividends gives most investors solace thru the reality or illusion of "control". I would agree that a mix, or blend, of the two seems to be the most desirable, as we must realistically acknowledge that management would usually be most aware of its own business conditions, such that its timing of purchases, similar to insider buys, would be more informed and of less market timing risk. Cheers!

[Mark Hake]

Again you make more money with buybacks. As I clearly pointed out some of that gain is in unrealized appreciation that is not taxed. Now if you need cash you either sell against the higher stock gains or borrow against it. I shouldn't have to point this out. in this case of dividends you are taxed at the income level. With long term gains you are not.

[hc351]

Buyback is more tax efficient. Yes.

But consider this: A does buybacks and B does dividends. Stock is $100 and buyback/dividend is $5. Tomorrow company goes bankrupt and is worth nothing. Investing in A means your return is -100% and B means you got $5 (down 95%), pre-tax. Buyback can be worse.

Buyback gives cash to selling shareholders. Remaining shareholders have a more concentrated bet in the company, so your outcome is more dependent on the future. Another way to think about this is that dividend is a forced selling mechanism. In the example, company B forced you to sell $5 before bankruptcy. In short, buyback makes good stocks better and terrible stocks worse.