Share buybacks and dividends are two common ways companies can distribute profits to their shareholders. Understanding the differences between the two can help investors make informed decisions about where to invest, and help companies decide on the best way to return value to their owners.

Both methods have their advantages and considerations for investors and corporations. First, we will examine dividends.

The case for dividends

Dividends are regular cash payments made by a company to its shareholders. They can provide a steady income stream for investors and are often seen as a sign of financial stability and profitability.

In Australia, we have a unique franking system to avoid double taxation of the income earned from dividends. Franked dividends are distributions paid out of the company’s profits that have already been taxed at the corporate level, which currently is a tax rate of 30 per cent. Shareholders can use that franked income to help reduce the tax liability of their dividend income, providing an efficient way to generate returns on investments.

A company’s circumstances will determine if it can provide fully franked, partially franked or unfranked dividends.

It’s also important to note that companies may not always have a consistent dividend policy, and dividends can be influenced by various macroeconomic factors and the company’s financial performance.

Investors also need to consider the impact of changes in tax laws and regulations on the attractiveness of franked dividends as an investment option.

The case for share buybacks

Share buybacks involve a company repurchasing its own shares from the open market. This reduces the number of outstanding shares, leading to an increase in existing shareholders ownership and potentially boosting the company’s share price.

Over the past 20 years, share buybacks have become a common practice among companies, but the reasoning behind this strategy is not always understood.

According to data from S&P Dow Jones Indices, buybacks in several markets have surpassed dividends in terms of total returns to shareholders¹. This trend has been driven by factors such as favourable tax treatment, low interest rates, and pressure from activist investors to enhance shareholder value.

Issuing bonds or debt to buy back shares has also become increasingly common and can be a strategic move when companies believe that their stock is undervalued.

By using debt financing to repurchase shares, companies are essentially taking advantage of cheaper financing costs compared to the potential future increase in share value. This could result in a higher return for shareholders in the long run.

However, for debt funded buybacks it’s worth examining how the additional debt impacts the company’s leverage ratio and interest expenses, and any potential impact on its credit rating.

Capital return strategies

Companies opt for share buybacks in addition to dividends for various reasons including:

1. Boosting earnings per share (EPS): By repurchasing their own shares from the open market, companies reduce the number of outstanding shares, subsequently increasing the ownership stake of existing shareholders in the company. This can lead to a higher EPS as the same earnings are now distributed among a smaller shareholder base, making each share more valuable.
2. Returning excess cash to shareholders: Rather than holding excess cash, companies may choose to return capital to shareholders through buybacks.
3. Flexibility: Buybacks can offer more flexibility for companies to adjust the amount and timing of capital returns based on market conditions and internal priorities. While dividends are a commitment by corporations to pay out a portion of profits to shareholders regularly, which can be reassuring for investors, this commitment can be seen as inflexible during times of financial stress. Buying back shares can provide flexibility and be used to support the stock price, adjust the capital structure, or reduce the dilution of stock options for employees.
4. Enhancing stock performance: Share buybacks can signal to the market that the company believes its stock is undervalued, potentially attracting more investors, and boosting the stock price.
5. Defensive measure: Companies may repurchase shares to prevent hostile takeovers or dilution of ownership.
6. Tax efficiency: Share buybacks can be a more tax-efficient way to return capital to shareholders compared to dividends, as shareholders have more control over when to realise the gains from selling their shares. Investors need to consider the tax implications of share buybacks which may be associated with potential capital appreciation, as they may be taxed differently to dividends depending on the jurisdiction.

There are other considerations to keep in mind when evaluating share buybacks. While they can provide a short-term boost to a company’s share price, the long-term implications may be less clear. Some critics argue that companies sometimes engage in buybacks to artificially inflate their stock prices. Companies need to balance their use of dividends and share buybacks with other capital allocation decisions, such as investing in growth opportunities or maintaining a strong balance sheet. In addition, companies may face criticism for prioritising short-term gains over long-term investments in research and development, capital expenditures, and employee development.

Conclusion

In summary, the choice between share buybacks and dividends is a strategic decision for both investors and companies. Investors need to consider their risk tolerance and income needs when evaluating these options, while companies must balance their capital allocation decisions to maximise shareholder value. The increasing popularity of share buybacks over the past 20 years reflects the evolving dynamics of the corporate landscape and the changing preferences of investors.

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¹ Examining Share Repurchases and the S&P Buyback Indices (spglobal.com)

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