What's the Difference between Dividends and Buybacks?

Companies reward their shareholders in two main ways—by paying dividends or by buying back shares of stock. An increasing number of blue chips, or well-established companies, are doing both. Paying dividends and stock buybacks make a potent combination that can significantly boost shareholder returns. But which is the better—stock buybacks or dividends?

The main difference between dividends and buybacks is that a dividend payment represents a definite return in the current timeframe that will be taxed, whereas a buyback represents an uncertain future return on which tax is deferred until the shares are sold.

Please note that in the United States, for the completed 2018 tax year, qualified dividends and long-term capital gains are taxed at 15% up to a certain income threshold ($425,800 if filing singly, $479,000 if married and filing jointly), and at 20% for amounts exceeding that limit.

Key Takeaways

  • Buybacks and dividends can significantly boost shareholder returns.
  • Companies pay dividends to their shareholders at regular intervals, typically from after-tax profits, that investors must pay taxes on.
  • Companies buy back shares from the market, reducing the number of outstanding shares, which can drive the share price higher over time.
  • In the long term, buybacks can help produce higher capital gains, but investors won't need to pay taxes on them until they sell the shares.

How Dividends and Buybacks Work

Both dividends and buybacks can help increase the overall rate of return from owning shares in a company. However, there's much debate surrounding which method of returning capital to shareholders is better for investors and for the companies involved over the long-term. Companies save a portion of their profits from year-to-year and put those accumulated savings into an account called retained earnings. Retained earnings is typically used for capital expenditures or big purchases such as factory equipment. Retained earnings, for some companies, can also be allocated to pay dividends or buy back shares in the open market.

Dividends

Dividends are a share of profits that a company pays at regular intervals to its shareholders. Although cash dividends are the most common, companies can offer shares of stock as a dividend as well. Investors like cash-dividend-paying companies, because dividends form a major component of an investment's return. Since 1932, dividends contributed to nearly one-third of total returns for U.S. stocks, according to Standard & Poor’s. Capital gains—or gains from price appreciation–accounted for the other two-thirds of total returns.

Companies typically pay out dividends from after-tax profits. Once received, shareholders must also pay taxes on dividends, albeit at a favorable tax rate in many jurisdictions.

Start-ups and other high-growth companies such as those in the technology sector rarely offer dividends. These companies often report losses in their early years, and any profits are usually reinvested to foster growth. Large, established companies with predictable streams of revenue and profits typically have the best track record for dividend payments and offer the best payouts. Larger companies also tend to have lower earnings growth rates since they've established their market and competitive advantage. As a result, the dividends help to boost the overall return for investing in the company's stock.

Buybacks

A share buyback refers to the purchase by a company of its shares from the marketplace. The biggest benefit of a share buyback is that it reduces the number of shares outstanding for a company. Share repurchases usually increase per-share measures of profitability like earnings-per-share (EPS) and cash-flow-per-share, and also improve performance measures like return on equity. These improved metrics will generally drive the share price higher over time, resulting in capital gains for the shareholders. However, these profits will not be taxed until the shareholder sells the shares and realizes the gains made on the shareholdings.

A company can fund its buyback by taking on debt, with cash on hand, or with its cash flow from operations.

Timing is critical for a buyback to be effective. Buying back its own shares may be regarded as a sign of management’s confidence in a company's prospects. However, if the shares subsequently slide for any reason, that confidence would be misplaced.

Example of a Dividend vs. a Buyback

Let's use the example of a hypothetical consumer products company that we will call Footloose & Fancy-Free Inc. (symbol FLUF), that has 500 million shares outstanding in Year one.

The shares are trading at $20, giving FLUF a market capitalization of $10 billion. Assume that FLUF had revenues of $10 billion in Year one and a net income margin of 10 percent, for net income (or after-tax profit) of $1 billion. The earnings per share is $2 per share (or $1 billion in profit / 500 million shares). As a result, the stock is trading at a price-to-earnings multiple (P/E) of 10 (or $20 / $2 = $10).

Suppose that FLUF is feeling particularly generous toward its shareholders and decides to return its entire net income of $1 billion to them. The dividend policy decision could play out in one of two simplified scenarios.

Scenario 1: Dividend

FLUF pays out $1 billion as a special dividend, which amounts to $2 per share. Assume you are a FLUF shareholder and you own 1,000 shares of FLUF purchased at $20 a share. You therefore receive $2,000 (1,000 shares x $2/share) as the special dividend. At tax time you pay $300 as tax (at 15%), for an after-tax dividend income of $1,700, or an after-tax yield of 8.5% ($1700 / $20,000 = 8.5%).

Scenario 2: Buyback

FLUF spends the $1 billion buying back FLUF shares. Companies typically execute its share buyback program over a period of many months and at different prices. However, to keep things simple for illustrative purposes, let's assume that FLUF buys back a huge share block at $20, which amounts to 50 million shares bought back or repurchased. The result is a reduction in the company's share count from 500 million shares to 450 million shares.

The 1,000 shares of FLUF purchased at $20 will now be worth more over time because the reduced share count will boost the value of the shares. Assume that in Year two, the company's revenues and net income are unchanged from Year one at $10 billion and $1 billion respectively. However, because the number of shares outstanding has been reduced to 450 million, earnings-per-share would be $2.22 instead of $2. If the stock trades at an unchanged price-to-earnings ratio of 10, FLUF shares should now be trading at $22.22 ($2.22 x 10), instead of $20 per share.

What if you sold your FLUF shares at $22.22 after holding them for just over a year and paid the long-term capital gains tax of 15%? You would be taxed on capital gains of $2,220 (i.e., ($22.22 - $20.00) x 1,000 shares = $2,220) and your tax bill in this case would be $333. Your after-tax gain would thus be $1,887, for an after-tax return of approximately 9.4% ($1,887 / $20,000 = 9.4%).

Advantages and Disadvantages of Dividends and Buybacks

Of course, in the real world, things seldom work out so conveniently. Here are some additional considerations with regard to buybacks versus dividends:

Returns Aren't Guaranteed

The future return with a share buyback is anything but assured. For instance, let's say that FLUF's business prospects tanked after Year 1, and its revenues fell 5 percent in Year 2. Unless investors are willing to give FLUF the benefit of the doubt and treat its revenue decline as a temporary event, it is quite likely that the stock would trade at a lower price-per-earnings multiple than the 10 times earnings at which it generally trades. If the multiple compresses to 8, based on an earnings-per-share of $2.22 in Year two, the shares would be trading at $17.76, a decline of 11 percent from $20 per share.

A Boost for Low-Growth Companies

The flip side of this scenario is one enjoyed by many blue chips, in which regular buybacks steadily reduce the number of outstanding shares. The reduction can significantly boost earnings-per-share growth rates even for companies with mediocre top-line and bottom-line growth, which may result in them being accorded higher valuations by investors, driving up the share price.

Wealth Building

Share buybacks may be better for building wealth over time for investors because of the beneficial impact on earnings-per-share from a reduced share count, as well as the ability to defer tax until the shares are sold. Buybacks enable gains to compound tax-free until they are crystallized, as opposed to dividend payments that are taxed annually.

In the case of non-taxable accounts where taxation is not an issue, there may be little to choose between stocks that pay growing dividends over time and those that regularly buy back their shares.

Disclosure

A major advantage of dividend payments is that they are highly visible. Information on dividend payments is easily available through financial websites and corporate investor relations sites. Information on buybacks, however, is not as easy to find and generally requires poring through corporate news releases.

Flexibility

Buybacks provide greater flexibility for the company and its investors. A company is under no obligation to complete a stated repurchase program in the specified timeframe, so if the going gets rough, it can slow down the pace of buybacks to conserve cash. With a buyback, investors can choose the timing of their share sale and consequent tax payment. This flexibility is not available in the case of dividends, as an investor has to pay taxes on them when filing tax returns for that year. Although dividend payments are discretionary for a dividend-paying company, reducing or eliminating dividends is not viewed favorably by investors. The result could lead to shareholders selling their shareholdings en masse if the dividend is reduced, suspended or eliminated.

Special Considerations

Which group of companies has performed better over time, the ones that consistently pay increased dividends or the ones that have the biggest buybacks?

To answer this question, let's compare the performance of two popular indexes containing dividend-paying companies and companies that issue buybacks.

The S&P 500 Dividend Aristocrats Index has companies that have raised dividends every year for the last 25 consecutive years or more. The S&P 500 Buyback Index has the top 100 stocks with the highest buyback ratios as defined by cash paid for share buybacks in the last four calendar quarters divided by the company's market capitalization.

Between March 2009 and March 2019, the S&P 500 Buyback Index had an annual return of 21.09% while the Dividend Aristocrats Index posted an annual return of 19.35%. Both surpassed the S&P 500, which had an annual return of 17.56% over the same period.

What about the 16-month period from November 2007 to the first week of March 2009, when global equities endured one of the biggest bear markets on record? During this period, the Buyback Index slumped 53.32%, while the Dividend Aristocrats was only slightly better, with a decline of 43.60%. The S&P 500 tumbled 53.14% during the same period.