Wise investors always value dividends, but many investors don’t realize that share buybacks can be just as valuable as dividends, and in some cases, more so.
Dividends are in fashion with investors, and that’s a good thing. But it’s odd that while investors periodically crave cash dividends, they rarely get excited about stock buybacks.
Creative accounting can produce false impressions of prosperity and hide embarrassing financial problems. But accounting can’t create cash for this year’s dividend, let alone conjure up a history of past dividends. If you restrict your stock market picks to dividend payers, you’ll avoid most of the market’s greatest disasters.
But in some ways, stock buybacks are better than dividends. In particular, they give you a tax-deferral option that you don’t get with cash dividends.
Two Ways Buybacks Raise Value
Stock buybacks raise the value of a given stock holding in two ways:
1. Stock buybacks raise a company’s earnings per share. Buybacks reduce the number of shares outstanding. To get earnings per share, you divide total earnings by the number of shares outstanding. With fewer shares, the calculation naturally gives you a higher number for earnings per share. On the whole, buyers are willing to pay slightly more for a stock with slightly higher earnings per share.
2. Share price rises. When the company buys back its own stock in the market, it bids up the price of the stock.
When you hold a stock in your personal, taxable account and it pays a cash dividend, you have to pay tax on the dividend in the year in which you receive it. If the company instead devotes the cash to a stock buyback, you have two options:
* If you need cash, you can sell part of your holding in the stock, presumably at a higher price than you’d get in the absence of a buyback. If you do that, you’ll pay taxes on the sale only if the stock has moved up since you bought. If the stock has moved sideways or down, the proceeds of your sale are tax-free.
* Of course, you’ll always have the option of holding on to your stock until it suits your purposes to sell.
This added opportunity for tax deferral may not seem like much of an advantage in any single year. However, the magic of compound interest applies to that tax deferral. It can add up to a huge advantage over a decade or two.
The advantage expands all the more if you hold off on selling until you need the money. That holding period may last until you retire, when your income tax rate is likely to be lower.
Overestimating the Value of Dividend Reinvestment Plans
The funny thing is that, just as investors tend to underestimate the value of a buyback, they overestimate the value of a dividend reinvestment program (DRIP). They put a high value on the fact that they can reinvest their dividends automatically, without paying brokerage commissions.
They fail to recognize that brokerage commissions are now at historic lows. They also overlook the fact that they have to pay taxes on the full dividend, even if they reinvest it. That tax hit and the loss of an opportunity for tax-deferred compounding greatly outweigh what they save on brokerage commissions.
Courtesy Fundata Canada Inc. © 2014. Patrick McKeough is a professional investment analyst and portfolio manager. He is the host of TSINetwork.com, where this article first appeared. Investments mentioned are not guaranteed and carry risk of loss.