Dividends and repurchases: what is the difference?

What is the difference between dividend and repurchase?

Companies return to shareholders in two main ways-paying dividends or repurchasing shares. More and more blue chip or mature companies are doing these two things. Dividend payment and stock repurchases form an effective combination that can significantly increase shareholder returns. But which is better-stock repurchase or dividends?

The main difference between dividends and repurchases is that dividend payments represent a definite return in the current time frame and will be taxed, while repurchase represents an uncertain future return, and the tax is postponed until the stock sale.

Please note that in the United States, for the full 2018 tax year, eligible dividends and long-term capital gains are taxed at 15%, up to a specific income threshold ($425,800 if declared separately, or $479,000 if married and filed together ), and the amount exceeding the limit is 20%.

Key points

  • Repurchase and dividends can significantly increase shareholder returns.
  • Companies pay regular dividends to shareholders, usually from after-tax profits that investors must pay taxes.
  • Companies repurchase shares from the market to reduce the number of outstanding shares, which may push up stock prices over time.
  • In the long run, buybacks can help generate higher capital gains, but investors do not need to pay taxes on stocks before selling them.

How dividends and buybacks work

Both dividends and repurchases help increase the overall rate of return on owning the company’s stock. However, there is a lot of debate about which method of returning capital to shareholders is better for investors and long-term participating companies. The company saves part of its profits every year and deposits these accumulated savings in an account called retained earnings.Retained earnings are usually used for capital expenditures or large purchases, such as factory equipment. For some companies, retained earnings can also be used to pay dividends or buy back shares on the open market.

Dividends

Dividends are the share of profits that the company pays to shareholders on a regular basis. Although cash dividends are the most common, companies can also offer stocks as dividends.Investors like companies that pay cash dividends because dividends are the main component of investment returns. According to Standard & Poor’s data, since 1932, dividends have accounted for nearly one-third of the total return on U.S. stocks.Capital gains — or gains from price increases — account for the other two-thirds of total returns.

Companies usually pay dividends from after-tax profits. After receiving dividends, shareholders must also pay dividend tax, although in many jurisdictions they pay tax at preferential tax rates.

Start-ups and other high-growth companies (such as companies in the technology industry) rarely provide dividends.These companies usually report losses in the early stages and usually reinvest any profits to promote growth. Large mature companies with predictable revenue and profit streams usually have the best dividend payment records and provide the best payment. Since larger companies have established their own market and competitive advantages, their earnings growth rates tend to be lower. Therefore, dividends help increase the overall return on investing in company stocks.

Repurchase

Stock repurchase refers to the company buying its shares from the market. The biggest benefit of stock repurchase is that it reduces the number of shares that the company has outstanding. Stock repurchases usually increase measures of profitability per share, such as earnings per share (EPS) and cash flow per share, while also improving performance indicators such as return on equity. Over time, these improved indicators usually push up stock prices, thereby bringing capital gains to shareholders. However, these profits will not be taxed until the shareholders sell their shares and realize equity gains.

Companies can fund their buybacks by assuming debt, cash on hand, or operating cash flow.

Timing is of the essence for the repurchase to be effective. Buying back one’s own stock may be seen as a sign of management’s confidence in the company’s prospects. However, if the stock price subsequently declines for any reason, this confidence will be misplaced.

Examples of dividends and buybacks

Let’s take a hypothetical consumer products company as an example. We call it Footloose & Fancy-Free Inc. (FLUF), which has 500 million shares outstanding in the first year.

The stock trading price is US$20, bringing FLUF’s market value to US$10 billion. Assume that FLUF’s revenue in the first year is 10 billion U.S. dollars, the net profit margin is 10%, and the net income (or after-tax profit) is 1 billion U.S. dollars. Earnings per share are US$2 per share (or profit of US$1 billion/500 million shares). Therefore, the price-to-earnings ratio (P/E) of the stock is 10 (or 20 USD / 2 USD = 10 USD).

Suppose FLUF is particularly generous to its shareholders and decides to return all of its $1 billion in net income to them. The dividend policy decision can play a role in one of two simplified scenarios.

Scenario 1: Dividend

FLUF paid US$1 billion as a special dividend, equivalent to US$2 per share. Suppose you are a shareholder of FLUF and you own 1,000 shares of FLUF purchased for $20 per share. Therefore, you will receive USD 2,000 (1,000 shares x USD 2 per share) as a special dividend. When paying taxes, you need to pay a tax of $300 (15%), the dividend income after tax is $1,700, or the after-tax rate of return is 8.5% ($1700 / $20,000 = 8.5%).

Scenario 2: Repurchase

FLUF spent US$1 billion to repurchase FLUF stock. Companies usually execute their stock repurchase plans at different prices within a few months. However, for the sake of illustration, let us assume that FLUF repurchases a large number of shares at a price of $20, which is equivalent to 50 million shares repurchased or repurchased. As a result, the number of shares in the company has decreased from 500 million shares to 450 million shares.

Over time, 1,000 shares of FLUF purchased for $20 will now be more valuable because the reduced number of shares will increase the value of the stock. Assume that in the second year, the company’s revenue and net income are the same as the value of the first year of 10 billion U.S. dollars and 1 billion U.S. dollars, respectively. However, since the number of outstanding shares has been reduced to 450 million shares, earnings per share will be $2.22 instead of $2. If the stock’s P/E ratio is 10, FLUF’s share price should now be $22.22 ($2.22 x 10) instead of $20 per share.

What if you sell FLUF stocks for $22.22 after holding them for more than a year and pay a 15% long-term capital gains tax? You need to pay a capital gains tax of US$2,220 (that is, (US$22.22-US$20.00) x 1,000 shares = US$2,220). In this case, your tax bill is US$333. Therefore, your after-tax income is US$1,887, and the after-tax return rate is approximately 9.4% (US$1,887/US$20,000 = 9.4%).

Advantages and disadvantages of dividend repurchase

Of course, in the real world, things rarely can be solved so easily. Here are some additional considerations regarding buybacks and dividends:

No guarantee of return

The future returns of stock repurchases are by no means guaranteed. For example, suppose FLUF’s business prospects decline after the first year, and its revenue drops by 5% in the second year. Unless investors are willing to let FLUF ignore it and treat its decline in revenue as a temporary event, the stock’s price-to-earnings ratio is likely to be lower than its usual trading price-to-earnings ratio of 10. If the multiple is compressed to 8, based on the second year’s earnings per share At US$2.22, the stock price will be US$17.76, which is 11% lower than US$20 per share.

Promoting low-growth companies

The other side of this situation is enjoyed by many blue chip stocks, where regular repurchases have steadily reduced the number of outstanding shares. Even for companies with mediocre revenue and profit growth, this reduction can significantly increase the earnings per share growth rate, which may cause investors to give higher valuations, thereby pushing up stock prices.

Fortune Building

Over time, stock buybacks may be more suitable for investors to accumulate wealth, because reducing the number of shares has a beneficial effect on earnings per share, and taxation can be postponed until the stock is sold. Repurchase allows income to be compounded tax-free until they are materialized, rather than annual taxed dividend payments.

For non-taxable accounts where taxes are not a problem, there may be little choice between stocks that pay growing dividends over time and stocks that regularly repurchase stocks.

Disclosure

One of the main advantages of dividend payments is that they are highly visible. Information about dividend payments can be easily obtained through financial websites and corporate investor relations websites. However, information about buybacks is not easy to find, and it is usually necessary to read company press releases carefully.

flexibility

Buybacks provide companies and their investors with greater flexibility. The company is not obliged to complete the prescribed repurchase plan within the specified time frame, so if the progress does not go smoothly, it can slow down the repurchase to save cash. Through repurchase, investors can choose the time of stock sale and subsequent taxation. This flexibility does not apply to dividends, because investors must pay taxes on them when they file their tax returns for the year. Although the dividend-paying company can decide to pay dividends on its own, investors are not optimistic about reducing or canceling dividends.As a result, shareholders may sell their shares collective If the dividend is reduced, suspended or cancelled.

special attention items

Over time, which group of companies has performed better, those companies that are increasing dividends or those that buy back the most?

To answer this question, let’s compare the performance of two popular indices that include dividend-paying companies and issuing repurchase companies.

Companies in the S&P 500 Dividend Aristocratic Index have increased their dividends every year for the past 25 consecutive years or more.The S&P 500 Repurchase Index has the top 100 stocks with the highest repurchase rate, which is defined as the cash paid for stock repurchases in the past four calendar quarters divided by the company’s market value.

From March 2009 to March 2019, the annual return of the S&P 500 Repurchase Index was 21.09%, while the annual return of the Dividend Aristocratic Index was 19.35%. Both surpassed the Standard & Poor’s 500 Index, which had an annual return of 17.56% over the same period.

During the 16 months from November 2007 to the first week of March 2009, the global stock market experienced one of the biggest bear markets in history. What about this period of time?During this period, the repurchase index plummeted by 53.32%, while the dividend aristocracy only slightly improved, a drop of 43.60%. During the same period, the Standard & Poor’s 500 Index fell by 53.14%.

.

READ ALSO:   The business model of Amazon and Alibaba: What is the difference?
Share your love