📈 Stock Buybacks & Dividends Explained
📈 Stock Buybacks & Dividends Explained
A comprehensive guide to how companies reward their investors
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Today at a glance:
Why Buffett & Munger Love Cannibals
The Tale of Two Strategies: Dividends and Buybacks
The Dividend Story
Dividends: A Double-Edged Sword?
The Buyback Blueprint
Buybacks: Boon or Bane?
The Face-off: Dividends vs Buybacks
In The Investor's Shoes
Lessons from the Field
Putting Knowledge Into Action
Why Buffett & Munger Love Cannibals
“Pay close attention to the cannibals.”
This quote from Charlie Munger has nothing to do with Hannibal Lecter.
He’s referring to “the businesses that are eating themselves by buying back their stock,” thereby generating returns for their long-term shareholders.
The Apple Effect
In 2014, the corporate world shook when Apple (AAPL) announced a massive $90 billion share buyback - one of the largest in history. This move signaled a shift in the tech giant's strategy. Instead of channeling funds into new products or ventures, Apple was investing in its own shares.
Berkshire Hathaway, led by Warren Buffett and Charlie Munger, was one company paying close attention. They first purchased Apple shares in 2016, a move that proved to be one of their best investments. Apple comprises nearly half of Berkshire's $325 billion stock portfolio today.
A Journey into the World of Buybacks and Dividends
So why are buybacks on Buffett and Munger's radar, and why should they be on yours?
In this article, we'll explain what to consider with stock buybacks and dividends. We'll uncover what they are, how they work, and the pros and cons of each strategy. We'll examine why companies might choose one over the other and how these choices impact investors.
Ready to explore these concepts with real-world examples? Let's dive in.
2. The Tale of Two Strategies: Dividends and Buybacks
Two Paths, One Destination
When it comes to returning profits to shareholders, companies typically have two main options:
Dividends.
Stock buybacks.
Each strategy provides a different path to the same destination—transferring wealth from the company to its shareholders.
Want to find a company's dividend payment and stock buybacks for a specific period? Just head to its investor relations website and look up the quarterly financial statements. Both dividends and buybacks are listed under 'financing activities.' Why there? Because they represent cash outflows to third parties – the shareholders.
Below is an example of Apple’s FY22 cash flow statement (ending in Setpember).
If you are a regular reader of this newsletter, you know how I love to put everything into a diagram. So let’s do the same thing with Apple’s cash flow statement.
Apple generated $122 billion of cash from its business operations in FY22. It returned most of it to shareholders the same year in the form of dividends ($15 billion) and stock buybacks ($89 billion).
A Regular Cash Payment: Dividends
Dividends represent a portion of the company's earnings distributed to shareholders through cash payments. It's like receiving a paycheck just for owning shares in the company. Some firms are known for their consistency and generosity when it comes to dividends, creating a steady stream of income for their shareholders.
A Share Reducing Strategy: Buybacks
On the other hand, stock buybacks involve a company purchasing its own shares on the open market. This process reduces the number of shares in circulation, essentially giving each remaining share a slightly larger piece of the company pie. It’s just math. If you lower the denominator, you end up with a larger number. The company aims to bolster its share price by reducing supply, indirectly benefiting existing shareholders.
These two strategies, although different, serve the same purpose – they're ways for a company to distribute excess cash to its shareholders. But, as we'll see, each approach carries its own set of implications for both the company and the shareholders.
3. The Dividend Story
The Power of Profit Sharing
You may have heard of “dividend aristocrats.” They are the companies that have increased their dividend for the past 25 years. There are 66 dividend aristocrats today, from 3M (MMM) to Walgreens (WBA) to Pepsico (PEP).
Imagine you're an investor in a company like Coca-Cola (KO), known for its reliable dividend payments. You're part of a grand tradition. Since 1920, Coca-Cola has consistently paid dividends to its shareholders, rewarding them with a portion of the company's profits every quarter.
In 2022, Berkshire Hathaway's initial $1.3 billion investment in Coca-Cola, which began after the 1987 market crash, yielded a staggering $704 million in dividends. This represents a 54% annual return, underscoring the potency of patient investing.
Types of Dividends
Dividends usually come as cash payments directly deposited into your account. However, some companies might opt for a stock dividend, granting you additional shares instead of cash. It's like the company saying, "Thanks for being with us. Here are more pieces of our pie."
Don't forget, you too can harness the power of dividends, even with smaller investments. Consider enrolling in a Dividend Reinvestment Plan (DRIP). It allows your dividends to be automatically used to purchase more company shares, even fractional ones, compounding your returns over time. It's like planting your own money tree that grows more robust with each payout. I do so with all my investments in dividend-paying companies.
How Dividends are Decided
So, how do companies decide their dividends? It often comes down to their dividend policy, a set of guidelines that dictate how much of their profits they will return to shareholders. Some factors influencing this policy could be the company's earnings, future investment opportunities, and overall financial health.
With this understanding of dividends, it's time to consider their pros and cons.
4. Dividends: A Double-Edged Sword?
A Reward for Shareholders
For shareholders, dividends can be a sweet deal. A regular income stream simply for owning a stock is a great perk, especially for income-focused investors.
But there's a catch.
The Tax Implication
Depending on your jurisdiction, you may need to pay tax on these dividends. In the United States, qualified dividends are typically subject to a 15-20% tax rate, which can vary based on your overall income level. Suddenly, that sweet deal tastes a bit bitter.
For the Company: Pros and Cons
Now, let's switch gears and look at the company's perspective. Regular dividend payments can project financial strength and stability, potentially attracting more investors.
However, dividends are a financial commitment. Companies that establish a regular dividend are expected to maintain it, which could be problematic in less prosperous years. A company like IBM saw its profits cut in half in the past decade but doubled its dividend payment over the same period, which is not sustainable.
Also, money paid out as dividends is money not reinvested in the business. This could limit a company's ability to fund new projects or expansions. Understanding these nuances is crucial when navigating the world of dividends.
Let's switch gears and look at the other strategy companies use to reward shareholders: stock buybacks.
5. The Buyback Blueprint
The Buyback Basics
When a company has surplus cash and feels its stock is undervalued, it may decide to buy back its own shares on the open market. This reduces the number of outstanding shares, potentially increasing the value of the remaining ones. Again, if the denominator is smaller (the number of shares), the value of each share naturally increases. It’s like cutting the same birthday cake into fewer slices. Each slice gets bigger.
The Buyback Process
The process starts with the company announcing its buyback intentions, including the number of shares it intends to repurchase and the time frame. Next, it buys the shares in the open market at current prices or offers shareholders a fixed price as part of a tender offer.
While dividends directly reward shareholders, buybacks offer a more indirect benefit. But is this method as advantageous as it seems? Let's explore.
6. Buybacks: Boon or Bane?
The Pros of Buybacks
Boost Earnings Per Share (EPS): With fewer outstanding shares, EPS generally increases. This can make the company appear more attractive to investors and potentially raise the stock price.
Flexibility: Unlike dividends, buybacks aren't a commitment. Companies can decide when and how many shares to repurchase based on their financial situation.
Tax Efficiency: Buybacks can be a more tax-efficient way of returning cash to shareholders, as capital gains taxes may be lower than income taxes on dividends. And you get to decide when you sell your share, so you are in control of the timing of your taxes.
Earnings Per Share (EPS) = [Net Income / # of outstanding shares]
Apple's Buyback Benefit
Take Apple, for example. In the past decade, thanks to an aggressive stock repurchase program, the company’s EPS has quadrupled, growing twice as fast as its net income.
The Cons of Buybacks
Short-term Gain: Critics argue that buybacks temporarily boost the stock price but don't improve the company's fundamentals.
Inefficient Use of Cash: Some say that companies should use excess cash for research and development or other investments to ensure long-term growth.
Income Inequality: As buybacks can inflate executive bonuses linked to EPS or stock price, critics argue they contribute to income inequality within the company.
IBM's Buyback Backfire
Consider IBM, which spent billions on buybacks over the years, some argue, at the expense of innovation. The result? The company struggled to keep up with competitors in the rapidly evolving tech industry.
In the grand scheme of things, are buybacks better than dividends? It's not a one-size-fits-all answer. Let's pit them against each other in the next section.
7. The Face-off: Dividends vs Buybacks
So, picture this. You're a top executive in a flourishing company that's just had an exceptional year. The revenue and profits are higher than ever, and you have a sizeable cash surplus. What do you do with it?
Option 1: Dividends - Give the shareholders a cut of the pie.
Option 2: Buybacks - You believe in the undervalued potential of your company and decide to buy back shares, thereby reducing their number and increasing their value.
Option 3: Reinvest or Reserve - Another viable strategy is to retain and reinvest these earnings into the business. This could be research & development, acquisitions, or capital investments that can drive future growth. Alternatively, companies may choose to keep a cash reserve for rainy days, helping to ensure financial stability in times of uncertainty or unexpected setbacks.
Every option has its merits and place, depending on factors such as the company's growth stage, financial health, investor expectations, and broader market conditions. Let's dive deeper into these considerations.
The Decision Factors
Your decision would depend on several factors:
Company's Stage: A company's stage and financial health can influence its decision between dividends and buybacks. Mature companies with steady profits often opt for dividends to return profits directly to shareholders. However, companies that perceive their shares to be undervalued, regardless of their development stage, might choose buybacks to consolidate value and potentially increase the price of the remaining shares.
Shareholder Expectations: Income-focused investors might prefer regular dividends, while others might appreciate the buybacks’ flexibility and tax efficiency.
Tax Laws: Depending on the tax laws in your country, one option might be more beneficial than the other.
In this fictional scenario, what might you choose? Your answer could well depend on what type of investor you are, which we'll explore next.
8. In The Investor's Shoes
As an investor, you might encounter scenarios where you must decide between a company that prefers dividends, one that opts for buybacks, or one that chooses to reinvest or reserve cash.
The Income-focused Investor
If you seek a steady income stream from your investments, you might lean towards the company offering regular dividends. These can provide a predictable return, akin to receiving a steady paycheck. Companies with a consistent history of paying dividends, like utility firms or real estate investment trusts (REITs), can be attractive. However, remember that dividends are usually subject to income tax.
The Price Appreciation Investor
A company conducting buybacks might be more attractive for those focused on asset growth. Buybacks can raise a company's stock price over time, offering a more significant payoff when you sell your shares. But be mindful that profits from selling these shares, known as capital gains, may also be taxable.
The Value Investor
Value investors look for stocks they believe are undervalued. They might prefer buybacks, especially if a company's shares seem underpriced. A company buying its own undervalued shares can signal confidence in its future potential, which is appealing to value-focused investors.
The Growth-oriented Investor
If you're an investor who appreciates long-term growth, a company that chooses to reinvest or reserve its profits might attract you. Reinvesting into R&D or other business enhancements can lead to product improvements, expansions, and other elements that boost the company's value in the long run. Meanwhile, having a cash reserve can help a company weather economic downturns or make strategic acquisitions. This approach might not provide immediate returns but could benefit long-term, patient investors.
Your investing journey will frequently involve such decisions. Gaining a robust understanding of dividends, buybacks, reinvestment strategies, and their tax implications can equip you to make informed choices as you navigate the path to wealth creation.
9. Lessons from the Field
Let's look at how some successful companies apply dividend and buyback strategies.
The Reliable Dividend-Payer: Johnson & Johnson
For over half a century, Johnson & Johnson has been increasing its dividends. It's a favorite among investors seeking steady income. The company's focus on maintaining and growing dividends shows its commitment to returning value to its shareholders.
The Avid Buybacker: Alphabet
Alphabet, the parent company of Google, often leans towards buybacks to distribute excess cash to its shareholders. The tech giant has an impressive cash generation capacity, racking up $91 billion from its operations in the 2022 fiscal year alone. Despite this, Alphabet has not yet ventured into paying dividends. Instead, it marked the previous year by repurchasing an astounding $59 billion worth of its own shares.
The Balance Master: Microsoft
Microsoft strikes a balance by paying dividends, performing share buybacks, and reinvesting in the business. Microsoft’s approach showcases how a company can use both methods to enhance shareholder value.
The Reinvestment Champion: Amazon
For some companies, the best strategy might not be returning cash to shareholders directly but instead reinvesting profits back into the business. Amazon is a prime example of this approach. Under the leadership of Jeff Bezos, the company famously prioritized growth and reinvestment over dividends or significant stock buybacks.
Instead of returning profits to shareholders directly, Amazon funneled its cash back into expanding its retail operations, building out its logistics network, and investing heavily in areas like cloud computing (Amazon Web Services) and artificial intelligence. The chart below mirrors Amazon's reinvestments in property, plant, and equipment (PP&E) with its operating cash flow.
This aggressive reinvestment strategy has paid off handsomely, as seen by Amazon's extraordinary growth and dominant market position. For growth-oriented investors, the company's continual reinvestment often provides more value than if it were to distribute dividends or engage in substantial buybacks.
The Unique Case: Berkshire Hathaway
Berkshire Hathaway has a unique approach. The conglomerate tends to neither issue dividends nor buy back its shares excessively. Instead, it has historically chosen to accumulate a sizable cash reserve.
Part of this strategy is inherent to the nature of Berkshire's core businesses. Insurance companies, which constitute a significant portion of Berkshire's holdings, inherently generate 'float,' or readily available funds resulting from collected premiums that have yet to be paid out for claims. These resources provide Berkshire a massive war chest that allows them to invest opportunistically in other businesses or stocks, weather economic downturns, and potentially conduct buybacks if shares are deemed significantly undervalued.
However, it's worth noting that even with their massive cash pile, Berkshire Hathaway has been careful and selective about its investments, preferring to wait for the right opportunity rather than making impulsive decisions.
Through these examples, we can see different successful applications of dividends and buybacks. Each company's strategy aligns with its financial situation, market position, and overall corporate strategy.
10. Putting Knowledge Into Action
As you've seen, the financial strategies of dividends and stock buybacks can significantly impact a company's attractiveness to different types of investors. Understanding these strategies and their implications equips you to make more informed investment decisions.
In the future, use this knowledge to assess potential investments.
Are you seeking a steady income? A company with a strong dividend policy might be your match.
Do you want to bet on a company's growth? Look for those executing buybacks, signaling confidence in their future.
Alternatively, you might be enticed by companies that reinvest profits or maintain ample cash reserves for stability or future growth opportunities.
Whatever your investment goal, remember that knowledge is your best tool. Use it wisely to navigate your financial journey, maximizing returns while minimizing risks.
That’s it for today!
Stay healthy and invest on!
Disclosure: I am long AAPL, AMZN, and GOOG in the App Economy Portfolio. I share my ratings (BUY, SELL, or HOLD) with App Economy Portfolio members here.
Well done. This encapsulates 3 types of companies well, in a simple manner, explained so the reader can really understand: buybackers, dividend payers, and growers.
Notably, sometimes growers are buybackers (eg, META, BABA), and sometimes divvy payers are also growers (but those are rare).
Overall I really liked the piece. One issue I had was with the idea that with share buybacks you own a larger piece of the pie and the pie stays the same. I believe this is a common misconception on wall street. While yes you do own more of a company if there are less shares outstanding, there is also less company to own. The company does not simply snap its fingers and buyback shares, it needs to spend cash to buy shares (cash that was previously owned by the shareholders). The reason shares increase after buybacks include: Wall Street realize that insiders believe the shares are undervalued and the insiders must know something the investors don’t (because they’re on the inside), and two the investors see less cash available to be burned on useless endeavors.