Dividend vs. Buyback: What's the Difference?

Companies reward their shareholders in two main ways—by paying dividends or by buying back their shares. An increasing number of blue chips are now doing both. Paying dividends and buying back shares is a potent combination that can significantly boost shareholder returns. But which alternative is the better one for investors?

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.

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

Dividends are a share of profits that a company pays at regular intervals to its shareholders. Investors like dividend payers because dividends form a major component of investment return, contributing nearly one-third of total returns for U.S. stocks since 1932, according to Standard & Poor’s (capital gains account for the other two-thirds).

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. Larger, established companies with more predictable profits are often the best dividend payers.

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. This usually increases per-share measures of profitability like earnings-per-share (EPS) and cash-flow-per-share, and also improves 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 crystallizes 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.

[Important: 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.]

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 out in Year 1. The shares are trading at $20, giving FLUF a market capitalization of $10 billion. Assume that FLUF had revenues of $10 billion in Year 1 and a net income margin of 10 percent, for net income (or after-tax profit) of $1 billion, or $2 per share. This means that the stock is trading at a price-to-earnings multiple (P/E) of 10 (in other words, $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. This 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 percent), for an after-tax dividend income of $1,700, or an after-tax yield of 8.5 percent ($1700 / $20,000 = 8.5 percent).

Scenario 2: Buyback. FLUF spends the $1 billion buying back FLUF shares. Although a company will execute its share buyback over a period of many months and at different prices, to keep things simple, we assume that FLUF buys back a huge share block at $20, which amounts to 50 million shares bought back or repurchased. This reduces its share count from 500 million shares to 450 million shares.

The 1,000 shares of FLUF that you 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 2, the company's revenues and net income are unchanged from Year 1 at $10 billion and $1 billion respectively. However, because the number of shares outstanding is now down 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.

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 percent? 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 percent ($1,887 / $20,000 = 9.4 percent).

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

• 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 2, the shares would be trading at $17.76, a decline of 11 percent from $20.
• The flip side of this scenario is one enjoyed by many blue chips, in which regular buybacks steadily reduce the number of outstanding shares. This 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.
• 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.

Which group of companies has performed better over time, the ones that consistently pay increased dividends or the ones that have the biggest buybacks? In order to answer this question, let's compare the performance of the S&P 500 Dividend Aristocrats Index (companies that have raised dividends every year for the last 25 consecutive years or more) against the S&P 500 Buyback Index (top 100 stocks with the highest buyback ratio as defined by cash paid for share buybacks in the last four calendar quarters divided by the company's market capitalization). Here's how the two stack up:

• Over the last 10 years, between March 2009 and March 2019, the S&P 500 Buyback Index and Dividend Aristocrats Index were fairly close, with an annual return of 21.09 percent and 19.35 percent respectively. Both surpassed the S&P 500, which had an annual return of 17.56 percent over this 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 percent, while the Dividend Aristocrats held up better, with a decline of 43.60 percent. The S&P 500 tumbled 53.14 percent during this period.

• 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 marketplace, reducing the number of outstanding shares and usually driving the share price higher over time.
• Longer term, buybacks will cause investors to see higher capital gains, but they won't have to pay taxes on them until they sell the shares.