Prime Numbers: Share repurchases and dividends: Which create more value? (2024)
Executives, investors, and the media often perpetuate the idea that repurchasing shares creates more value than paying dividends does. This can’t be further from the truth. Share repurchases may increase a company’s earnings per share, but for a fairly valued company, they don’t necessarily translate into higher valuethan seen with dividend payments.Let’s say your company earns $100, has a P/E of 15 on core earnings, and can distribute $100 in excess cash earned as either dividends or share repurchases (exhibit):
Dividend payments. If your company pays out dividends, its equity value will be $1,500. Shareholders will have received $100, so the total value to the shareholders will be $1,600. On a per share basis, the share price will be $15. Since each share will also have received $1 in dividends, the total value and cash per share will be $16.
Share repurchases. If your company pays out its earnings by repurchasing shares, its equity value will be $1,500, and shareholders will have received $100. On a per share basis, for those shareholders who don’t sell, each remaining share will increase in value to $16 because of the lower share count. For an individual (remaining) share, this is economically equivalent to having a share worth $15 plus $1 from a dividend.
Note that earnings per share increasemechanically; it has nothing do to with underlying value creation. If your company pays out a dividend, shareholders retain their shares and receive cash. If your company repurchases shares, the selling shareholders receive cash, and the remaining shareholders have shares with higher value (but they don’t receive any cash). Overall, there is no change in underlying value, just a change in the mix of shareholders.
Vartika Gupta is a solution manager in McKinsey’s New York office, where David Kohn is an associate partner; Tim Koller is a partner in the Denver office; and Werner Rehm is a partner in the New Jersey office.
For a full discussion of market dynamics, see Valuation: Measuring and Managing the Value of Companies, seventh edition (John Wiley & Sons, 2020), by Marc Goedhart, Tim Koller, and David Wessels.
From the perspective of income investors, dividend payouts create far more value than share repurchases. Whereas buybacks usually work in favor of the company, dividend payouts offer more flexibility for the investor by giving them the choice to collect cash or buy more shares.
The Bottom Line. Although many investors may think that buyback programs are benefiting them, intentions are often in favor of the company itself, and more specifically company insiders. Dividends on the other hand ensure direct payment to the shareholder, with much less risk than share buybacks.
Public companies use share buybacks to return profits to their investors. When a company buys back its own stock, it's reducing the number of shares outstanding and increasing the value of the remaining shares, which can be a good thing for shareholders.
A buyback will increase share prices: Stocks trade in part based on supply and demand, and a cut in the number of outstanding shares often causes a price increase. Therefore, a company can increase its stock value by creating a supply shock through a share repurchase.
Share repurchases usually offer company management more flexibility than cash dividends by not establishing the expectation that a particular level of cash distribution will be maintained. Companies can pay regular cash dividends supplemented by share repurchases.
After a stock goes ex-dividend, the share price typically drops by the amount of the dividend paid to reflect the fact that new shareholders are not entitled to that payment. Dividends paid out as stock instead of cash can dilute earnings, which can also have a negative impact on share prices in the short term.
High-growth companies are not always profitable as they tend to aggressively invest in growing the business. Because they operate in this relatively aggressive business cycle, high-growth companies tend not to pay dividends. Rather than return cash to shareholders this way, they tend to reinvest it.
The dividend yield measures how much income has been received relative to the share price; a higher yield is more attractive, while a lower yield can make a stock seem less competitive relative to its industry.
With a buyback, the company can increase earnings per share, all else equal. The same earnings pie cut into fewer slices is worth a greater share of the earnings. By reducing share count, buybacks increase the stock's potential upside for shareholders who want to remain owners.
On the balance sheet, a share repurchase would reduce the company's cash holdings—and consequently its total asset base—by the amount of cash expended in the buyback. The buyback will simultaneously shrink shareholders' equity on the liabilities side by the same amount.
The effect of a buyback is to reduce the number of outstanding shares on the market, which increases the ownership stake of the stakeholders. A company may buy back shares because it believes the market has discounted its shares too steeply, to invest in itself, or to improve its financial ratios.
Given that much higher return potential, investors should consider automatically reinvesting all their dividends unless:They need the money to cover expenses. They specifically plan to use the money to make other investments, such as by allocating the payments from income stocks to buy growth stocks.
A share repurchase reduces a company's available cash, which is then reflected on the balance sheet as a reduction by the amount the company spent on the buyback. At the same time, the share repurchase reduces shareholders' equity by the same amount on the liabilities side of the balance sheet.
First, they provide a regular income stream, which can be especially attractive to income-focused investors such as retirees. Second, dividends are often seen as a sign of a company's financial health and stability, as they indicate that it's generating enough profits to distribute at least some to shareholders.
Introduction: My name is Nathanael Baumbach, I am a fantastic, nice, victorious, brave, healthy, cute, glorious person who loves writing and wants to share my knowledge and understanding with you.
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