Dividend Investing (Part 3): A More "Flexible" Dividend Strategy
18:29 Share

This show is a proud member of the Retirement Podcast Network.

When a company is profitable, they have a decision to make about what to do with those profits. They can invest those profits back into the business to fuel future growth. They can acquire another company, pay down debt, and or share the profits with investors through the form of a dividend. But there's another increasingly popular option. Profitable companies can also elect to buy back their own stock from existing shareholders, a process that's cleverly referred to as a stock buyback.

According to the Wall Street Journal, over the past five years, large cap U.S. companies have spent nearly $4 trillion of profits repurchasing their own stock from existing investors. While it may not be evident at first glance, stock buybacks are really nothing more than a flexible dividend. They're a method of returning excess profits back to shareholders. But on

But unlike traditional dividends, buybacks don't get the same type of positive attention. In fact, many suggest that stock buybacks are a form of market manipulation that line the pockets of CEOs and hinder future growth of the company.

Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And today in part three of our dividend investing series, I'm sharing everything that you need to know about stock buybacks. Specifically, I'm sharing what a stock buyback is, how they work, and how they might be more advantageous to investors than dividends. To view the research and articles referenced in today's episode, just head over to youstaywealthy.com forward slash 219.

Last year, during his State of the Union address, President Biden criticized companies for engaging in stock buybacks, suggesting that buybacks mostly benefit CEOs and hinder economic growth. To discourage this increasingly popular activity, he has proposed quadrupling the federal tax on share buybacks from 1% to 4%. But

But is that true? Are stock buybacks bad? Are CEOs lining their own pockets, starving their own companies and hindering economic growth by buying back shares of their own stock? To objectively answer these questions, we first need to better understand what a stock buyback is and how they work. As I've highlighted a few times in this series, successful, profitable companies have to regularly decide what to do with their excess cash above and beyond what's needed to fund future projects and growth.

Naturally, existing shareholders would prefer for that excess cash to come back to them instead of it aimlessly sitting in the company's bank account at risk of potentially being spent misappropriately.

Historically, companies have not had an alternative to sharing excess cash with investors other than by paying out dividends. So that's what they did up until 1982. In 1982, the Securities and Exchange Commission removed the ban on stock buybacks. And as a result, companies began returning more cash to shareholders through buybacks than through dividends.

More specifically, every year from 1997 to 2023, the value of stock buybacks for S&P 500 companies has outpaced dividends. So what is a stock buyback? How does it work? And why does it accomplish more or less the same thing that a dividend does? Let's use Apple to help explain. Let's say that Apple, a publicly traded company, has excess cash right now above and beyond what's needed to fuel its future growth.

To share some of this excess cash with investors, Apple announces a stock buyback program, a process where they will use some of this excess cash to buy back shares of its own stock on the open market from investors that want to sell. I.e. this is voluntary for existing shareholders of Apple. They aren't obligated to sell any of their stock.

But when Apple does buy back some of its stock from those who want to sell, it reabsorbs a portion of the company that was previously owned by investors, just like you and me. In other words, executing a stock buyback means that there will be fewer shares of Apple stock in circulation for investors to own.

It also means that existing shareholders who do not participate in the buyback and don't sell any of their shares of stock will end up owning a larger percentage of the company. I'll say that again, existing shareholders who don't participate in the buyback and don't sell any of their shares of stock will end up owning a larger percentage of the company. I know it can get a little confusing. So let me try to explain the math behind that statement in an overly simplified example.

Let's pretend that there are a total of 1,000 shares of Apple stock in circulation owned by investors all over the world. Let's also pretend that I personally own 100 of those shares. If I own 100 shares of the 1,000 that are in circulation, that would mean that I own 10% of the company. 100 divided by 1,000 equals 10%.

Now, if Apple decides to buy back 200 shares from willing shareholders through a stock buyback program, the total number of outstanding shares in circulation would drop to 800.

If I don't sell any of my stock during the buyback period, and I continue to hold on to my 100 shares, I would now own 100 shares of the now 800 that are outstanding, which would represent a 12 and a half percent ownership of the company. 100 divided by 800 is 12 and a half percent. I have the same amount of shares, but I now own a larger percentage of the company at the conclusion of the stock buyback program.

This is more or less how stock buybacks work, but the actual real life numbers and percentages are of course much smaller for mom and pop investors like you and me. For example, as of this recording, Apple has just over 15 billion shares of stock in circulation. So if you own 100 shares of Apple stock,

Out of the 15 billion that are in circulation, your ownership stake is a tiny, tiny, tiny decimal that your calculator doesn't even have enough room to display. But the math still works the same way. If Apple buys back 500 million shares from the existing 15 billion that are outstanding through a stock buyback, and you continue to hold on to your 100 shares, you will have a slightly higher percentage of ownership as a result.

Now, it could be a slightly higher percentage of a company that's going downhill by the day, or it could be a slightly higher percentage of a great company with a healthy long-term outlook who has a track record of returning excess profits to shareholders without hindering future growth.

The same could be said for traditional dividends. A 5% dividend might look great on paper, but is it a 5% dividend from a great company trading at an attractive valuation or a 5% dividend from a junkie overvalued company that's trying to do everything it can to remain appealing to investors? So now we know how a stock buyback affects investors who do not participate and choose to hold on to their existing shares. They end up with a slightly higher percentage of ownership.

But what about the investors that do participate in the buyback? How does it affect them? Why would they want to participate? Well, choosing to sell some of your shares during a stock buyback period is kind of like receiving a traditional dividend payment and choosing to pocket the cash instead of reinvesting that dividend back into the company that paid it to you.

The company issuing the dividend is returning some of their excess cash to you, the investor. It's providing you with some liquidity so you can do something else with that money. That something else could be spending the cash proceeds to fund living expenses, but it could also be investing in a different company.

Selling shares through a stock buyback is essentially the same thing. Through a stock buyback, a company like Apple is providing you, an existing shareholder, with some liquidity. They're offering to return to you some of the value they've created. But instead of giving you a cash dividend, which would in turn reduce the share price of the stock, they're giving you some of their excess cash in return for some of your existing shares.

As I shared in part one of the series, if you spend a dividend that you receive, you'll maintain the same number of shares of stock, but at a lower price per share on the day the dividend is paid. If you participate in a stock buyback, you'll end up with fewer shares of stock, but at the same price per share on the day of execution. Again, both dividends and stock buybacks accomplish the same thing. They are methods of returning excess cash to investors.

But unlike a taxable dividend that you will receive whether you want it or not, an investor does not have to participate in a stock buyback. They can opt out and skip the taxable event, hence why buybacks are often referred to as a flexible dividend. More on some of the key differences such as tax treatments later, but before we get there, what about the company offering the stock buyback? How does it affect them and why are they doing this?

Well, just like paying out a dividend, when a company buys back shares of its own stock, it's parting ways with excess cash. I either company has less cash on its balance sheet as a result of the stock buyback. Again, both dividends and buybacks are methods of returning excess profits to investors. Profits that the company has determined are not needed to fuel future growth.

Now, the reasons why a company would buy back its own shares are less straightforward and begin to venture into the world of speculation. But one reason why a company might do a stock buyback is similar to why a company would pay a dividend.

The company is attempting to signal to investors that the company is healthy, so healthy that it has excess cash on hand that it doesn't even need to maintain future profitability. Another reason might be that the company thinks the current share price of its stock is lower than it should be. It's undervalued. In that case, the strategy is for the company to buy back some of the shares at current market prices and then wait to sell them when the stock price goes up and more accurately reflects the value of the company.

Buying back stock can also help reduce the company's cost of capital, increase its earnings per share, or consolidate ownership.

Buying back stock can also be a sign of a company in distress. It doesn't take long to find historical examples of stock buybacks gone wrong. Lehman Brothers spent roughly $4 billion buying back stock in 07 and 08. We all know how that story ended. From 2004 to 2013, Bed Bath & Beyond spent nearly $12 billion buying back stock. Last April, the company filed for bankruptcy.

There are countless reasons, and it's not always clear exactly why a company wants to buy back its own stock and what a stock buyback might mean for its future. But if you want to explore the reasons why a company might pursue stock buybacks in more detail, I'll share a few articles in today's show notes, which can again be found by going to youstaywealthy.com forward slash 219.

But to recap and summarize everything we've discussed up to this point, when a company buys back shares of its own stock, three things happen. Number one, the company ends up with less cash on its balance sheet and fewer shares of stock in circulation. Number two, investors who participate in the buyback end up with more cash in their pocket and fewer shares of stock.

Number three, investors who do not participate don't receive any cash. They maintain the same number of shares of stock and a higher percentage of ownership in the company. So now that we hopefully have a better grasp of this topic, let's revisit the questions posed at the beginning of this episode. Are stock buybacks bad? Are CEOs lining their own pockets, starving their companies and hindering economic growth by buying back shares of their own stock?

As Jason Zweig put it, quote, buybacks are neither bad nor good. They are simply a tool. Just as you can use a hammer to either build a house or knock one down, buybacks are useful in the right corporate hands and dangerous in the wrong ones. Suggesting that buybacks starve companies and hinder growth implies that the same management we should not trust to allocate excess cash correctly in a buyback will allocate it correctly for other purposes.

What Jason is saying here is that profitable companies have to do something with their excess cash. That something stock buyback or not could be good or bad for the future of the company.

On the surface, many are quick to assume that companies who reinvest back into the business is a better use of profits than simply taking excess cash and giving it back to shareholders through a buyback or through a dividend. On paper, sending cash back to shareholders versus using it to, let's say, hire the best engineers to create a world-changing programmable computer chip, i.e. NVIDIA, seems like a poor use of capital. And that's a reasonable assumption.

But the research says otherwise. In short, there are two types of companies, high investment companies that reinvest a high percentage of profits back into the business and low investment companies that are more focused on returning excess cash to shareholders.

Contrary to what many assume, research concludes that low investment companies actually outperform high investment companies over long periods of time. More specific to today's topic, research has concluded that companies who buy back their shares outperform companies that reinvest a larger percentage of profits back into the business.

As Ben Carlson put it in an old article on this topic, quote,

One of the greatest investors of all time, Warren Buffett, agrees with this as well by saying, quote, when companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as stock repurchases.

At the end of the day, this really just ends up being a growth stock versus value stock decision. Younger, high growth companies don't have excess profits to share with investors. They're reinvesting everything back into the business. Older, more established companies generate consistent cash, often more cash than they need, opening the door for stock buybacks and or the issuance of dividends.

It's not that buybacks or dividends prevent good companies from reinvesting more money back into the business. It's that these good companies don't need to reinvest more money back into the business than they already are. And they've determined that returning some cash to shareholders is a better decision.

As Ben noted, some high growth companies like Amazon or Nvidia make wise internal investments and end up doing very well. But on average, investors overpay for these exciting growth companies and most of them end up underperforming over long periods of time, which brings us back to the key ingredient to successful investing, to focus on buying quality investments at a good price and

It just so happens that successful high quality companies often return excess cash to shareholders because they can, because they are established healthy companies that don't need the excess cash to continue to maintain growth and profitability.

As noted in part two of the series, dividend investing or low investment companies that have a track record of returning excess cash to shareholders is really just rooted in value investing. Dividends or no dividends, buybacks or no buybacks. What is most important is that investors focus on buying quality companies at attractive valuations while avoiding expensive overvalued ones.

While stock buybacks and dividends more or less accomplish the same thing, they return excess cash to shareholders. It's important to highlight before we part ways today, one of the biggest benefits to stock buybacks, and that is taxes. As mentioned earlier, investors don't have a choice when it comes to a dividend. If the investor does not want a dividend that they've received, they'll just reinvest it back into the company that paid it. However,

However, they'll still pay taxes on the dividend in the euros received, ordinary income taxes. On the other hand, a stock buyback is optional. It's only a taxable event if the investor sells appreciated shares back to the company during the buyback period. And if the shares are held for longer than a year, it's taxed at the often more favorable capital gains tax rates.

If an investor does not sell shares during a stock buyback because they believe in the future of the company and they want to continue participating in the upside, they end up with a higher percentage ownership of this great company that they believe in and no tax bill at all. So if I'm a long-term investor who doesn't really need or want cash flow from my investment or liquidity, I'd prefer for the company to do a stock buyback than to pay me a dividend every quarter.

If you want to learn more about the potential tax benefits of stock buybacks, I'll link to some articles in today's show notes. And I know I got a little technical today, but I thought it was important to dissect this often controversial topic that doesn't get discussed very often or even make its way into dividend investing conversations. So to summarize all of this and the most important points, just like dividends, stock buybacks are a method of returning excess cash to shareholders.

Returning cash to shareholders, whether through dividends or buybacks, don't hinder the growth of the company. Great companies are able to return excess cash to shareholders because they don't need it to continue being great companies.

On the other hand, just because a company pays a dividend or repurchases shares of stock doesn't make them a great company. It's important that investors ensure that they're buying good companies at good prices. Many of those companies will likely pay dividends and or repurchase stock through stock buyback programs.

Lastly, depending on investor situation, stock buybacks are typically more tax favorable to investors than dividends. Once again, to learn more about all this, to learn more about stock buybacks, their history, the tax benefits, the pros and cons, and the academic research, just head over to youstaywealthy.com forward slash 219.

Thank you very much for sticking with me today. Thank you all for listening. And I will see you back here next week.