The recent articles on dividend policy vs. stock buybacks muddle a very important distinction. Namely, a firm declaring a special dividend and a firm utilizing a dividend policy emphasizing growth in dividends are two very different things. Stating that an investor prefers firms that emphasize growing dividends to firms that conduct share buybacks is not an accurate comparison because share buybacks are generally a use of capital in an absence of other opportunities to utilize that capital while a dividend growth policy relates to a firm that is inherently growing as exemplified by the growth in its dividend. Although a firm could in theory continuously conduct buybacks in lieu of paying regular dividends, since firms generally do not tend to do so, the only accurate comparison for a real world scenario should be between stock buy backs and a special dividend, both of which represent a form of returning capital to investors in the absence of other growth opportunities for which that capital can be used.
In reality, in a tax free environment, an investor should be agnostic concerning a firm's decision to pay a dividend or participate in share buybacks so long as the buyback price is equivalent to the current value obtained from the dividend discount model.
We can illustrate with an example. Let's say company X is worth $10000 with 1000 shares outstanding at a price of $10/share. The Firm also has $1000 dollars in cash and does not see any opportunities where the cash can be used to help the firm and thus wants to return the cash to investors.
Special Dividend Scenario
The firm decides to reward its investors with a special dividend of $1/share. Effectively the Firm pays out $1000 and its current market value is reduced to $9000. There are still 1000 shares outstanding and each is now worth $9. Thus an investor with ten shares now has ten shares worth $9 each and $10 in cash as opposed to previously when he had ten shares worth $10 each and is still “worth” $100. There is no change in his current value and he has a choice on whether he wants to reinvest that dividend in the Firm thus conducting a synthetic share buyback or use the dividend money elsewhere.
Share Buy Back Scenario
The Firm decides the optimal course would be to conduct a share buyback and proceeds to purchase $1000 worth of shares either in the open market or through a tender of $10/share. The buyback will allow the firm to purchase 100 shares and reduce the amount of shares outstanding to 900. The Firm is once again worth $9000 dollars (900 outstanding shares multiplied by $10 per share) and due to the buyback there are 900 shares outstanding. Thus each share is still worth $10 ($9000 market value divided by 900 shares outstanding) and an investor has the same $100 of value for his 10 shares as they did before the buyback and as they would if the firm had paid a special dividend. In addition, the investor can easily replicate a synthetic special dividend by selling one share for $10 and thus would have 9 shares worth $90 total and $10 in cash.
Non-tax free environment
Share buy backs are often preferred by investors in a non tax free environment because dividends, even when reinvested, are considered ordinary taxable income that cannot be offset with capital losses. Thus while a special dividend forces the investor into a tax event, a share buyback allows the investor a choice of whether they would like to create a tax event for themselves. Thus, for a taxable investor that would like to reinvest their capital, it is preferable if the firm conducts a buyback. For example if we use our former scenario for an individual with a 30% tax rate and who obtained the shares at no cost (to make things simple for tax reasons):
Special Dividend - The investor receives $10 in cash and after taxes can reinvest $7, thus his total investment stands at $97.
Share Buyback – The buyback does not create a tax event and thus the investor is still invested the initial $100.
Now let’s say the investor would like cash instead and has recognized capital losses of $10.
Special Dividend - The investor receives $10 in cash taxed as ordinary income and ends up with $7 after taxes. Combined with his loss of $10, the investor is down $3.
Share Buyback - The investor sells one share for $10 and has capital gains of $10. This is offset with the $10 in capital losses and thus the investor is net zero.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.