What You Need To Know About Share Repurchases by Sure Dividend

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Share repurchases are the most misunderstood way for a corporation to return cash to shareholders.

Nearly everyone understands dividends. Dividends are simply money paid out from the corporation to its shareholders.

Share repurchases are similar in that money is returned to shareholders, although not directly.

With share repurchases (also called share buybacks), a company buys its own shares to reduce the amount of shares outstanding. A simple example is below:

Imagine a corporation has 100 shares outstanding. You own 10 of these shares; you have 10% ownership of the corporation.

Now imagine that the company uses some of its cash to buy out one of your fellow shareholders – say shareholder owns 20 shares. After the share repurchases, the company has 80 shares outstanding. You own 10 of them. This gives you 12.5% ownership of the company.

The benefit of share repurchases is that current shareholders own a greater percentage of the corporation. Share repurchases are in effect a ‘forced’ dividend reinvestment program.

Share Repurchases Versus Dividends – Taxes

Are share repurchases or dividends better for shareholders? It depends on the situation.  Qualified dividends are taxed at between 0% and 23.8% in the United States for taxable accounts.

Tax consequences reduce the value of dividends. Share repurchases do not suffer from the same taxation weakness. Shareholders reap the benefits of share repurchases without incurring any taxes at the time of the repurchase.

Of course, share repurchases really are taxed if one includes capital gains taxes. Another simple example will illustrate this point:

Imagine a corporation’s stock is trading at $50 a share. It has 20 million shares outstanding. If the corporation were to somehow repurchase 10 million of its shares outstanding, the company’s stock price would rise to $100 a share all other things being equal. If an investor then sold their shares, they would incur a long-term capital gains tax rate of between 0% and 23.8% on their gains.

All of the gains in the example above were a result of share repurchases. When one sells their stock, they will have to pay the same tax rate on their gains from share repurchases as they would on their gains from dividends.

Share repurchases do have one tax advantage over dividends. With share repurchases, you do not have to pay your taxes upfront. Instead, you get to keep the money you would have to pay in taxes compounding in the business. Dividends – even when reinvested – trigger a taxable event. Share repurchases do not.

Share Repurchases Versus Dividends – Management Incentives

Corporations often reward their C-level executives with incentive packages. Often, these incentive packages are based on a stock hitting a certain price.

There is no easier way to ‘game’ this system than to repurchase shares.

You may be thinking “that’s fine, this just aligns management and shareholder incentives. After all, shareholders benefit from share repurchases”.

The truth is, share repurchases can destroy shareholder value.

If shares are repurchased when a stock is trading above its intrinsic/fair value, management is effectively spending $1 to buy less than $1 in value. This is not good.

When a stock is overvalued, it is far better for management to return cash to shareholders through dividends rather than share repurchases. If a stock is significantly overvalued, it would actually be beneficial for management to issue shares and return the proceeds to investors as dividends. Sadly, I know of no examples of this occurring in the real world.

Unfortunately, management is incentivized to destroy shareholder value by repurchasing shares when the stock price is overvalued.

Just because share repurchases are occurring, this does not mean that a company’s management is shareholder friendly.

Share Repurchases & Debt

Share repurchases are often funded through debt issuance. The image and quote below from John Hussman illustrate this point:

“drives buyback activity is not value, but the availability of cheap, speculative capital at points in the business cycle where profit margins are temporarily elevated and make the increased debt burden seem easy to handle. The chart below showed the developing situation a few years ago…”

Share Repurchases

Being able to borrow money should not be the prime criteria for share repurchases.

Should businesses use debt to finance share repurchases? It depends on the situation.

As discussed earlier in this article, if a stock is overvalued, shares should not be repurchased – regardless of how repurchases are financed. Using debt to repurchase overvalued shares is even worse than using cash to do so.

The first criteria for using debt to repurchase shares is the company’s stock must be undervalued.

If this criteria is met, then things become more interesting.

In some cases, a business can issue bonds with interest rates lower than its stock’s dividend yield. In these cases, debt fueled share repurchases are very beneficial. They reduce the amount of shares outstanding and reduce the company’s future cash flow obligations.

As an example, if a stock has a 5% dividend yield and can issue debt with 4% interest, issuing debt and repurchasing shares will reduce cash outflows by 1% while simultaneously increasing shareholder ownership. This is a win-win situation. Click here to see what real-world company does this.

If a company’s shares are undervalued, issuing debt to finance share repurchases can be good for shareholders if the company has highly stable cash flows. Over leverage has destroyed many a business.

Corporations tend to over leverage themselves during the ‘good times’, and then run into trouble during recessions.

Companies with excess debt loads already, or companies that perform poorly during recessions should not use debt to repurchase shares. Highly stable businesses will likely realize greater total returns by commencing on debt funded share repurchases when the stock is trading below fair value.

Final Thoughts

Share repurchases are, on average, beneficial for shareholders.

The very best capital allocators will only repurchase shares when their stock price is trading below fair value.

When a stock is trading above fair value, dividends are a far better way to return cash to shareholders.

High quality businesses with stable cash flows that are also undervalued make good candidates for share repurchases.