Value Investing

Michael Mauboussin – Share Buybacks Are A Better Alternative For Shareholders Than Dividends

There is much debate about whether companies should increase shareholder value by repurchasing their shares or returning excess cash to shareholders by way of dividends. One of the best papers written on the subject is Share Repurchase From All Angles, by Michael Mauboussin where he makes the case for share buy-backs over dividends as the best method of adding value for existing shareholders.

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Here’s an excerpt from the paper:

  • Here’s a very basic question: If you own the shares of a company because you believe the stock is undervalued, why would you ever want the company to pay a dividend instead of buying back shares? If you believe the shares are undervalued then you should always favor a buyback because buybacks add value for continuing shareholders at the expense of selling shareholders.
    As Warren Buffett wrote in Berkshire Hathaway’s 1984 annual report, “When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.” Perhaps the final phrase would be more accurate if it read, “no alternative action can benefit ongoing shareholders as surely as repurchases.”
  • If the company of a stock that you own is buying back shares, you must recognize that doing nothing is doing something—increasing your percentage ownership in the company. As a consequence, if you are a longstanding shareholder it is inappropriate to criticize management for having bought back stock at a higher price. Provided that management used a proper process to assess the merit of the buyback, they have come to the same conclusion as you have (assuming that you own the shares because you think they are undervalued). Companies and investors have to make decisions in the face of incomplete information and uncertainty.
  • Encourage the companies you own to adhere to the golden rule of buybacks: A company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available. Most executives think in terms of “growth versus no-growth” rather than “value creation versus value destruction.” There are times when repurchasing shares is more attractive than investing in the business.
  • Shareholders who want a dividend can simply create one by selling a pro-rated amount of stock. As with a normal cash dividend, a synthetic dividend leaves the shareholder with cash and the same proportionate ownership of the company. Buybacks are generally more favorable than a dividend because there is no reinvestment risk and little friction. A synthetic dividend is a good solution for shareholders who want cash for current consumption.
  • Investors frequently use past total shareholder return (TSR) as a guide to anticipate future returns. Here’s a simple formula to calculate TSR, where g is the annual rate of price appreciation and d is the dividend yield:
    TSR = g + d(1+g)
    The problem is that with stocks that pay dividends, almost no investors earn the total shareholder return. This is because dividends are often taxable and generally don’t get reinvested back into the stock (either because of consumption or because the dividends are allocated to other investments). Said differently, a shareholder only earns the TSR if he automatically reinvests 100 percent of his dividends back into the stock in a tax-free account, which rarely happens.  In contrast, companies that return cash to shareholders via buybacks allow their ongoing shareholders to earn the TSR.
  • Shareholders seek to buy the shares of companies when the price in the market is well below the value. The larger the discount between value and price, the higher the expected return to shareholders (all else being equal) as the market closes the gap between the two. Provided a shareholder is right in his assessment of price and value, he should always prefer a buyback to a dividend because a buyback increases the value per share for continuing shareholders.

You can read the full document, Share Repurchase From All Angles here.