Dividend and Stock Buybacks – Is it Good or Bad
84Value investors can be generally classified into two broad categories, viz. investors looking for long-term portfolio appreciation and investors looking for regular dividend pay-outs. It should be noted that the free cash flow generated by a company is much more important than its annual dividend pay-out and hence value investors should concentrate more on the free cash flow while making investment decisions.
The free cash flow generated by a company can be used in a number of beneficial ways, viz. repaying debt, dividend pay-outs, acquisitions, expansion of production capacity and finally, stock buybacks. Today we shall focus on the various advantages of a stock buyback and its effect on the stock price in the long term.
Increase in EPS
Companies generally buyback their own stock when they have an excess of cash on their books, a low level of debt and when they are not interested in acquisitions or other investments. Companies also buyback stock when they feel that the stock price is cheap or undervalued. When a company undertakes a stock buyback, it effectively decreases the number of outstanding shares in the market. This leads to an increase in the EPS (Earnings Per Share) and therefore leads to a higher stock price.
Tax Benefits
Capital gains are taxed at a lower rate than dividend income in many countries. Companies based in such countries may choose to go for a stock buyback instead of a dividend pay-out to lower tax outflows and benefit their shareholders. In the Singaporean context, this is simply not applicable as there is no capital gains tax in Singapore.
Benefits the Staff
Compared to a regular dividend pay-out, a stock buyback leads to an appreciation in the stock price. Since most company managements own a significant chunk of the company’s stock through ESOPs, it is obvious that a stock buyback would be more beneficial to the company’s employees than dividend pay-outs.
Tempers Shareholder Expectations
The fundamental difference between stocks and bonds is the fact that bonds pay a fixed rate of interest while stocks are under no compulsion to pay dividends. On the other hand, there are companies like Starhub and SingTel which have a long history of regular dividend pay-outs. The shareholders of such companies expect dividend pay-outs year after year and even a small cut in the dividend leads to criticism of the company management. Such companies are forced to pay dividends every year and this impedes their ability to add production capacity and acquire other companies thereby affecting stock performance in the long term. In contrast, a company that undertakes a stock buyback rewards shareholders only when the company can afford to do so. This controls shareholder expectations and leads to better capital allocation boosting the stock price in long term.
It’s All about the Allocation
A stock buyback generally adds to shareholder value, but this is not always the case. A stock buyback carried out at very high valuations is detrimental to the future of the company. Similarly, stock buybacks should be avoided whenever there are more profitable avenues for investment. For e.g. YangZiJiang is a great company with a professional management. Instead of going for a stock buyback, the company management chose to invest its surplus funds in Chinese bonds with a 10% yield. This decision has greatly benefited the company’s finances and will lead to an increase in its share price.
In conclusion, a stock buyback is generally a very positive development for shareholders. Additionally, stock buybacks also allow shareholders to review the management’s capital allocation skills which are extremely important for the growth of any company.
