I will tell you the answer first, and this is an answer that I will use a lot. It depends. Stock buy-backs can be good or bad, depending on whether the stock is over- or under-valued. It’s that simple. Now let’s go over the details.
When a company makes a profit, it can do one of five things with the money:
1. Pay a dividend
2. Buy back shares of stock
3. Re-invest money in the company so that it can expand
4. Buy other companies to expand
5. Pay obscene amounts of money to management
In the future, I will deal with expansion and M&A (mergers and acquisitions). There are pitfalls to both paths, but both can also be good. Needless to say, I do not approve of Option 5. So let’s talk about stock buy-backs and dividends.
The traditional course for a company with little room for expansion and no opportunities for acquiring other companies is to pay out most of earnings in dividends. This is what utility companies do (see Progress Energy [[PGN]], for example). There is one problem with this, though. The company’s earnings, which have already been taxed as corporate earnings, are taxed again as dividend income to shareholders (now at a 15% rate). Much of that money therefore benefits Uncle Sam rather than the shareholders. Why not find a way to benefit the shareholders without giving the government a cut?
The way to do this is for the company to buy back shares of its own stock. Let’s say our company, Acme Brick, earned $1 million in 2004. They are in a mature industry and have little room to grow. Therefore, they decide to buy back shares of their stock. Let’s say there are one million shares outstanding, each selling at $10. The company is thus valued at $10 million. With its $1 million in profit, Acme buys back 100,000 shares, bringing the total number of shares down to 900,000. Each share now has 10% more value, since it represents 10% more of the company.
Rather than being paid in cash, the shareholders have been paid in ownership. They get no extra cash, but they now own a 10% larger stake in the company. The price of the shares should not actually change, since the 10% larger stake in the company is offset by the company now having $1 million less in cash, and thus being worth 10% less.
If the money had instead been paid out as a dividend, the shareholders would have received a 10% dividend in cash, but would have been taxed on that dividend, so they would only receive 85¢ on the dollar due to taxes. Again, because the company, after paying the dividend (it is now ex-dividend), no longer has $1 million in cash, it’s value will fall by that amount. The company will now be worth $9 million, with shares worth $9. Like with a stock buyback, there is no net gain or loss to the shareholders (except for the taxes on the dividends). (See box on the previous page for a longer explanation.)
Note that with small dividends, the market price of the stock may not change after the dividend date. However, with larger dividends, the price will drop by an amount equal to the dividend. We have seen that, because of the tax benefits, stock buybacks are often better than dividends. There is just one last factor to consider: the price of the stock. If a company buys back shares for less than the intrinsic value of those shares, then the buyback really benefits shareholders. The company is buying something for less than it is worth, and that is always good.
If a company’s stock is overvalued, however, it should pay a dividend rather than buy back its shares. In buying its shares, it would be paying too much, and thus destroying the wealth of the shareholders. So, in the end, it comes down to whether the stock is a good value or not. If it is not a good value, then the company should not be buying it. Then again, neither should we.
Some companies that have recently announced large stock buybacks include Progressive [[pgr]], Home Depot [[hd]], and Wyndam [[wyn]].
Disclosure: I own no shares in any company discussed in this post. See the disclosure policy.