As the chief research officer of Buckingham Strategic Wealth, I receive lots of questions about both dividends and share buybacks. And there are lots of misunderstandings. With that in mind, I thought it important to explain the impact of these two different ways companies use to return capital to shareholders.

While dividends tended to be the preferred payout in the 1970s and ’80s, buybacks have seen increasing use. There are two reasons for that. First, for taxable investors, dividends are a less tax-efficient means of returning capital because taxes are due on the full amount received. On the other hand, buybacks have no tax impact unless shareholders create a “self-dividend” through the sale of some of their holdings in order to generate cash. If they do so, tax is due only on the portion that is above their cost basis. Thus, taxable investors should have a clear preference for buybacks over dividends. Second, corporate executives with stock options prefer buybacks because dividends lower the price of the stock by the amount of the dividend. And options have become a more important source of compensation over the last few decades.

In its paper “By the Book: Do Share Repurchases Impact Price-to-Book as a Measure of Value?” Dimensional noted that while buybacks have increased in use, the total amount of capital returned to shareholders remained at its average of about 4.4 percent since 1976.

With that in mind, we will examine how the two different methods of returning capital impact valuation metrics such as the price-to-book (P/B) ratio.

The Impact on P/B

Consider the following example. Stock A with a market capitalization of $1,200,000 and a book value of $1,000,000 will have a P/B ratio of 1.2. Suppose that company would like to return $200,000 of capital to shareholders. Regardless of whether it does this through a share repurchase program or through a cash dividend, the impact on price-to-book is the same.

READ ALSO  ING combines commodity trade finance teams, names new division head

If the company chooses to repurchase shares, market capitalization and book value both decline by the amount of the repurchase. The decline in market value occurs through a drop in the number of shares outstanding. The book value declines because the company reduces cash to fund the share repurchase. Following a $200,000 share repurchase, the new market capitalization is $1,000,000, the new book value is $800,000, and the P/B ratio is 1.25.

Whenever a company repurchases shares above book value, it lowers the per share book value, making the stock appear to be more expensive on that basis. The reverse is true when a repurchase is made below book value. This has led to criticism of P/B as a valuation metric.

If the company pays a cash dividend, market capitalization and book value both decline by the amount of the dividend. Market capitalization falls because the dividend results in a decline in price. This is an important point lost on many investors who prefer dividends. The dividend is not really income (except for tax purposes), it’s just a return of capital. Book value declines because of the reduction in cash to pay the dividend. Following a $200,000 cash dividend, the new market capitalization is $1,000,000, the new book value is $800,000, and the P/B ratio is 1.25. This is identical to the share repurchase case.

Again, we see that when a company pays a dividend when its stock is trading above book value, it lowers the book value per share, making the stock look more expensive – exactly the same as with repurchases.

READ ALSO  UN agency hit with corruption allegations at climate projects

It’s also important to note that while share buybacks lower the book value of a company, they tend to boost earnings per share. They also tend to boost return on equity (ROE), making the company appear more profitable. However, they also increase the financial leverage of the company, making it riskier. Thus, it’s not clear what the impact will be on share price.

Dimensional then addressed the impact of cash distributions on other metrics.

What About Other Value Metrics?

Cash distributions are likely to have less impact on P/B than on other types of valuation ratios, such as price scaled by earnings, cash flows or sales. This is because cash distributions will impact both market capitalization and book equity, but may not have an equivalent offset in earnings, cash flows, or sales.

For example, suppose the company in our previous illustration had annual earnings of $60,000, resulting in a price-to-earnings (P/E) ratio of 20.0 before any distribution. If the company were to pay out $200,000 in dividends or through a share repurchase, the market capitalization would fall by the distribution. It is unclear, however, if that distribution would have any impact on earnings, cash flows, or sales. If earnings were to stay the same, the P/E ratio would fall from 20.0 to 16.7. Therefore, scaling price by a variable other than book value may not mitigate the potential impact of distributions on the valuation ratio.

What conclusions should investors draw?

Summary

First, investors should not have a preference for dividends over buybacks, yet many do because they fail to understand the equivalency on a pretax basis and ignore the negative tax consequences. Remember, dividends are not income, except for tax purposes. Instead, they are just one way to return capital. And investors who need cash flow can utilize self-dividends by selling a sufficient number of shares, a more tax-efficient way to generate cash flow.

READ ALSO  Five Reasons Ethereum Is Way More Powerful Than Bitcoin (Cryptocurrency:BTC-USD)

Second, because P/B can be impacted by either dividends or buybacks, an ensemble of valuation metrics should be used. That can be accomplished by screening stocks for not only P/B but also profitability, or by using multiple valuations metrics such as P/E, price-to-cash flow (P/CF), and price-to-sales (P/S) to determine the eligible universe.

Important Disclosure: The contents of this article are for information and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. The information contained in this article is based upon third-party information and is deemed to be reliable, however its accuracy cannot be guaranteed. Third-party information may become outdated at any time without notice. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The company mentioned in this article is hypothetical.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com