If a company wants to return value to shareholders, the buyback is the way to go.

Don’t get me wrong. Dividends have their place. And some investors will always be attracted to that cash every quarter.

But ideally, buybacks are extremely efficient ways to distribute wealth back to the shareholder. Here’s why:

1. No immediate tax hit. When you receive a dividend check, within the year you will be paying 15% of it to the Federal Government. And President Bush actually lowered it to that rate from a high of 38%. Who knows what that rate will be when a new administration moves in. But with a buyback, there is no immediate tax hit. When you actually sell shares, you’ll pay taxes on the gain you’ve made (if any), and that’s it. So, after tax, a $100 dividend is worth less to you than $100 of stock repurchased by a company from you.
2. You’re in control. The more you think about it, dividends are a bit of a burden. The company throws them off with regularity and you have to deal with the tax consequences. Of course, there’s that old saying about it actually being a blessing to have tax problems… But wouldn’t it be better if you were able to tell the company when you wanted a dividend? With a buyback, shareholders can choose to get involved or to ignore it. The shareholder gets a choice.

For a lot of high-profile companies, big buybacks are reducing share counts and giving loyal investors a bigger slice of the pie…

IBM, Intel, and Oracle have been very active purchasers of their own company stock. Of course, there are other factors at play. But the bottom line is that over the last 10 years, these large-cap players have brought down their share count and increased their earnings per share.

But what is happening when a company keeps buying back their stock, and shares outstanding keep going up?

Well, one of the causes could be that the company is buying back stock in an attempt to counter the exercise of employee stock options. And if you watch how investors react to these kinds of buybacks, they clearly hate them. That’s because this type of buyback is a knee-jerk reaction to try to maintain a consistent share base. It has nothing to do with whether or not management thinks their stock in under-priced or not.

The bottom line: Watch out for companies with share bases that increase despite massive buybacks, and avoid companies who buy back shares indiscriminately. If management buys its own stock back when it is expensive, it is destroying shareholder value, plain and simple.

Until next time,

Craig Walters
February 8, 2007

Value of Buybacks vs. Value of Dividends was originally featured in the Penny Sleuth.