F&P Quarterly: Buyback vs dividends – How to navigate through the value distribution landscape

Share buybacks have recently become an increasingly strong trend although it is not a new phenomenon. Announced buybacks in the US in 2018 reached a new record level of 1 100 billion and although this trend has not reached Europe to its full extent, we can already see European companies launching buyback programs or extending their current ones. With this in mind, it is important for executive management and the board of directors to understand how to be perceived as a company that drives shareholder value.

What are share buybacks and why do companies choose it instead of paying dividends? 

Critics of buybacks often say that it has nothing to do with improving business operations or fundamentals. For a buyback program to be initiated, company executives need to believe that reducing the number of outstanding shares and thereby boosting EPS (Earnings Per Share) is a more valuable use of cash than making investments to improve operations.

However, buybacks risk sending dual signals; either it implies that a company lacks profitable or growth-driving investment opportunities, including M&A. Or on the other side – it could indicate that the management team deem the company to be undervalued.

For investors it is also a trade-off between EPS and yield, or possible growth given that there are profitable existing investment opportunities.

One contributing factor for the rising popularity of buybacks is tax-related. When a dividend is paid out it is paid with after-tax profits and once received, the shareholders must also pay tax on dividends. On the other hand, buyback is an uncertain future return on which tax is not paid until the shares are sold, with the advantage of being able to defer tax payments. This gives buybacks’ an edge from a financial perspective. In addition to possible tax-benefits, decreasing the number of outstanding shares improves a number of key metrics, such as:

•    Return on Equity
•    Return on Capital Employed
•    Earnings Per Share
•    Free Cash Flow Per Share

Once the shares are bought off the open-market, companies have two options, either keeping them in treasury or cancelling them, reducing the number of total outstanding shares.

Management teams and investors are aligned – Boards are stuck in the middle

On a side note it should be noted that management teams often have personal incentives for initiating buyback programs, as it boosts the value of variable parts of their remuneration packages which often include option and share allocations.

However, it’s not only management teams who are pushing for buyback programs. The pressure often comes from investors, especially hedge funds, who use EPS trend as one of their main metrics. Buyback programs can also help boosting the share price in periods of lower demand, as buybacks don’t have to be evenly spread throughout the year.

With management teams having incentives for buyback programs, aligned with the will of specific investors – the board of directors can be caught in the middle.

One way to conclude the alternatives is through looking at the S&P 500 Dividend Aristocrats Index, which includes companies who have increased their dividends on an annual basis for 25 years or more, compared with the S&P 500 Buyback Index (the 100 stocks with the highest buyback ratio).  However, there are no clear-cut winner amongst these indexes, as the outcome depends on what time horizon that is chosen.

With buybacks on the rise and management teams being aligned with specific investors, there is risk for boards to be caught in the middle, why it is important for companies to have a clear and coherent value distribution strategy.