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Author Topic: Do Buybacks Obsolete Dividends under current Tax Code?  (Read 1444 times)
theonewhowaskazu
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July 27, 2014, 01:21:52 AM
 #1

when a company has cash on hand, it generally can either reinvest that money in the business (or keep it liquid, point is, the value is still locked into the business), or pay a dividend to shareholders, or buy back its own shares. Investors generally like it to be paid out because it gives them the freedom to choose what they want to do with their money. Obviously management would prefer to keep the money in the company, because with more money, they can either grow the company more, or pay themselves more, either of which generally results in making their own life easier. But, lets assume investors have their way and get management to agree to pay out some money. How should it be done?

The answer is usually paying a dividend or buyback. Lets compare those two options.

Dividend is pretty obvious. It takes a certain amount of money that the company owns and pays it out to shareholders in small increments each quarter.

Stock buyback is where the company takes the amount of money that it would otherwise distribute in a dividend, and uses it to buy its own stock, thereby raising the % ownership of all the stockholders.

The fact of the matter here is that these two approaches are practically equivalent. If you got a dividend, and didn't want the cash, so instead of taking the cash, decided to automatically re-invest the dividend, your ownership would increase by exactly the same % as if the company had just bought back stock.

On the other hand, if you wanted to keep your % ownership the same, you could easily have just sold shares if they did a buyback, and got the exact same % cash return as if they had just paid a dividend.

Okay, maybe you don't get "exactly the same", maybe there's some fees/spread on either end, but the end result is about the same. The difference with buybacks is that you don't have to pay taxes until you actually sell the stock, but with dividends, you've got to pay tax on the dividends no matter what.

Why then does any company ever pay a dividend? Why do preferred stock pay fixed dividends instead of promising fixed $ volume of buybacks? Hell, you could even structure a bond through buybacks if you really wanted.

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July 27, 2014, 01:56:32 AM
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Buybacks tend to help current top management when it receives compensation from stock options.  By "returning" capital via buybacks the stock price increases, when doing so via dividends, the price declines.

Until the Bush administration dividends were taxed at ordinary rates while capital gains were taxed at a lower rate, so there was some reason to do buybacks.  However, as you note, almost always investors would prefer cash in hand via a dividend.

I generally view buybacks as fairly self serving.

Preferred stock is basically just an unsecured loan.
theonewhowaskazu
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July 27, 2014, 02:05:32 AM
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Buybacks tend to help current top management when it receives compensation from stock options.  By "returning" capital via buybacks the stock price increases, when doing so via dividends, the price declines.

Until the Bush administration dividends were taxed at ordinary rates while capital gains were taxed at a lower rate, so there was some reason to do buybacks.  However, as you note, almost always investors would prefer cash in hand via a dividend.

I generally view buybacks as fairly self serving.

Preferred stock is basically just an unsecured loan.

The reason to do buybacks is as I noted the potential to defer taxes  . . .
And as I noted after a buyback, one can simulate a dividend by selling a proportional amount of stock...

Also theoretically (only in theory, in practice it doesn't work out this way) buybacks shouldn't raise the price because the company is spending a proportional amount of value, reducing the equity of the company proportionally to the number of shares it bought back. Unless people sold proportionally, to simulate a dividend, in which case the price would go down.

Same thing for dividends, if people reinvested dividends.

Although point taken about the options.

And preferred stock is different from unsecured lending for a variety of reasons, the primary of which is that it isn't unsecured.

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July 27, 2014, 06:00:39 AM
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no. Dividends allow shareholders to receive current cash flow while dividends allow shareholders to receive a potentially higher share price in the future when they sell their shares. Cash today is much more valuable the. Cash tomorrow or otherwise in the future.
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July 27, 2014, 04:48:22 PM
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Buybacks tend to help current top management when it receives compensation from stock options.  By "returning" capital via buybacks the stock price increases, when doing so via dividends, the price declines.

Until the Bush administration dividends were taxed at ordinary rates while capital gains were taxed at a lower rate, so there was some reason to do buybacks.  However, as you note, almost always investors would prefer cash in hand via a dividend.

I generally view buybacks as fairly self serving.

Preferred stock is basically just an unsecured loan.

The reason to do buybacks is as I noted the potential to defer taxes  . . .
And as I noted after a buyback, one can simulate a dividend by selling a proportional amount of stock...

Also theoretically (only in theory, in practice it doesn't work out this way) buybacks shouldn't raise the price because the company is spending a proportional amount of value, reducing the equity of the company proportionally to the number of shares it bought back. Unless people sold proportionally, to simulate a dividend, in which case the price would go down.

Same thing for dividends, if people reinvested dividends.

Although point taken about the options.

And preferred stock is different from unsecured lending for a variety of reasons, the primary of which is that it isn't unsecured.
You need to remember the NPV of cash today, even if taxed, is still worth more then the NPV of cash years from today, still taxed. An investors income from a stock is going to be taxed regardless, it is just a matter of when, but in both scenarios the profits will be taxed when the investment is turned into cash.
theonewhowaskazu
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July 27, 2014, 05:07:08 PM
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no. Dividends allow shareholders to receive current cash flow while dividends allow shareholders to receive a potentially higher share price in the future when they sell their shares. Cash today is much more valuable the. Cash tomorrow or otherwise in the future.

Except you can sell your shares today, and receive more money now. Or you can wait for the future and sell then. You choose. There's no opportunity cost lost. Say you own 10% of a company worth $1B. They buyback 10% for $100M, leaving the company worth $900M. Now you own 11.11% of that company, which is worth still $100M. You can now sell 1.11% of the company for $10M, while still owning 10% of the company. Thats the exact same thing that would have happened if they had simply paid a 10% dividend. The only difference is in this case you had the option to not sell that additional 1.11% stake, and defer your taxes.

Logically, there shouldn't be any tax on a company distributing its value to shareholders, in which case this wouldn't matter. But there is, so it does.

Quote
You need to remember the NPV of cash today, even if taxed, is still worth more then the NPV of cash years from today, still taxed. An investors income from a stock is going to be taxed regardless, it is just a matter of when, but in both scenarios the profits will be taxed when the investment is turned into cash.
1) Even with a buyback, you can still realize the gains today and have it taxed now, if you want. Its just with dividends, you have to do so, while with buybacks, you get the choice to do that or not.
2) Because tax levels are tiered, the NPV of cash today is not necessarily worth more than the NPV of cash years from today, still taxed. Moreover, if you choose not to sell your increased % share, thereby not collecting your "synthetic dividend", you aren't simply getting delayed cash. You're investing more into the same project. Thus as long as that project continues to generate higher returns than the interest rate, it makes sense to do so. This is why people reinvest dividends sometimes. The difference between this and dividends is that with dividends, if you reinvest, you still get taxed, now. With buybacks, you don't have to be taxed now, since your money is automatically reinvested. You can choose to withdraw that reinvested money by selling shares, but if you do so, you will be taxed. Same as if you had just gotten a dividend.

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August 01, 2014, 02:04:50 AM
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Buybacks tend to help current top management when it receives compensation from stock options.  By "returning" capital via buybacks the stock price increases, when doing so via dividends, the price declines.

Until the Bush administration dividends were taxed at ordinary rates while capital gains were taxed at a lower rate, so there was some reason to do buybacks.  However, as you note, almost always investors would prefer cash in hand via a dividend.

I generally view buybacks as fairly self serving.

Preferred stock is basically just an unsecured loan.

The reason to do buybacks is as I noted the potential to defer taxes  . . .
And as I noted after a buyback, one can simulate a dividend by selling a proportional amount of stock...

Also theoretically (only in theory, in practice it doesn't work out this way) buybacks shouldn't raise the price because the company is spending a proportional amount of value, reducing the equity of the company proportionally to the number of shares it bought back. Unless people sold proportionally, to simulate a dividend, in which case the price would go down.

Same thing for dividends, if people reinvested dividends.

Although point taken about the options.

And preferred stock is different from unsecured lending for a variety of reasons, the primary of which is that it isn't unsecured.
You need to remember the NPV of cash today, even if taxed, is still worth more then the NPV of cash years from today, still taxed. An investors income from a stock is going to be taxed regardless, it is just a matter of when, but in both scenarios the profits will be taxed when the investment is turned into cash.
This is a very good point. Dividends will generate cash for shareholders "today" while share buybacks will generate "cash" "tomorrow" in the form of higher share prices over time and higher earnings per share over time. Additionally companies tend to purchase their own shares via share buybacks when their shares are expensive and issue new shares when share prices are cheap, thus destroying value for shareholders.

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theonewhowaskazu
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August 01, 2014, 09:19:24 PM
 #8

Buybacks tend to help current top management when it receives compensation from stock options.  By "returning" capital via buybacks the stock price increases, when doing so via dividends, the price declines.

Until the Bush administration dividends were taxed at ordinary rates while capital gains were taxed at a lower rate, so there was some reason to do buybacks.  However, as you note, almost always investors would prefer cash in hand via a dividend.

I generally view buybacks as fairly self serving.

Preferred stock is basically just an unsecured loan.

The reason to do buybacks is as I noted the potential to defer taxes  . . .
And as I noted after a buyback, one can simulate a dividend by selling a proportional amount of stock...

Also theoretically (only in theory, in practice it doesn't work out this way) buybacks shouldn't raise the price because the company is spending a proportional amount of value, reducing the equity of the company proportionally to the number of shares it bought back. Unless people sold proportionally, to simulate a dividend, in which case the price would go down.

Same thing for dividends, if people reinvested dividends.

Although point taken about the options.

And preferred stock is different from unsecured lending for a variety of reasons, the primary of which is that it isn't unsecured.
You need to remember the NPV of cash today, even if taxed, is still worth more then the NPV of cash years from today, still taxed. An investors income from a stock is going to be taxed regardless, it is just a matter of when, but in both scenarios the profits will be taxed when the investment is turned into cash.
This is a very good point. Dividends will generate cash for shareholders "today" while share buybacks will generate "cash" "tomorrow" in the form of higher share prices over time and higher earnings per share over time. Additionally companies tend to purchase their own shares via share buybacks when their shares are expensive and issue new shares when share prices are cheap, thus destroying value for shareholders.
Actually its a terrible point for reasons I just finished explaining.

Say you hold $11 in stocks today.
Or you hold $10 in stocks + $1 in dividends.

The NPV of BOTH THESE ITEMS is the same, even though the $1 in stocks is in stocks not cash. Why? Because if the NPV of that $1 worth of stock wasn't $1, then it wouldn't trade for $1. Yes, the NpV of $1 today is worth more than $1 tomorrow, but the NPV of $1 today and $1 in stocks today IS the same (primarily because you could just liquidate the stock if you really wanted to.

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August 03, 2014, 05:22:25 AM
 #9

Actually its a terrible point for reasons I just finished explaining.

Say you hold $11 in stocks today.
Or you hold $10 in stocks + $1 in dividends.

The NPV of BOTH THESE ITEMS is the same, even though the $1 in stocks is in stocks not cash. Why? Because if the NPV of that $1 worth of stock wasn't $1, then it wouldn't trade for $1. Yes, the NpV of $1 today is worth more than $1 tomorrow, but the NPV of $1 today and $1 in stocks today IS the same (primarily because you could just liquidate the stock if you really wanted to.

Agree. A dividend is a way of 'forcing' a stockholder to convert a portion of his holding into cash. A buyback gives him the option of doing so, if he so desires.
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August 03, 2014, 06:00:29 AM
 #10

Actually its a terrible point for reasons I just finished explaining.

Say you hold $11 in stocks today.
Or you hold $10 in stocks + $1 in dividends.

The NPV of BOTH THESE ITEMS is the same, even though the $1 in stocks is in stocks not cash. Why? Because if the NPV of that $1 worth of stock wasn't $1, then it wouldn't trade for $1. Yes, the NpV of $1 today is worth more than $1 tomorrow, but the NPV of $1 today and $1 in stocks today IS the same (primarily because you could just liquidate the stock if you really wanted to.
This is not true. The present value of cash today is higher then the present value of cash tomorrow. A dividend allows a shareholder to receive cash today while still owning the same percentage of the company. A share buyback allows a shareholder to give up future cash flow in exchange for cash today.

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polynesia
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August 03, 2014, 09:49:57 AM
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This is not true. The present value of cash today is higher then the present value of cash tomorrow. A dividend allows a shareholder to receive cash today while still owning the same percentage of the company. A share buyback allows a shareholder to give up future cash flow in exchange for cash today.

What you mean is the present value of 'x' units of cash today is higher than the present value of 'x' units of cash tomorrow.
If you look at pure IRR, dividends and share buybacks are exactly the same. It is only taxes which make one form more efficient than the other.
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