Misnomers in comparing stock buybacks to dividends

Question

I found this question particularly helpful:Are stock buybacks similar to dividends?

Not too far off from this angle, my textbook has this as an introduction to stock buybacks:

Share repurchases are an alternative to cash dividends as a way of distributing cash to shareholders, and they have the same effect on shareholders' wealth as cash dividends of the same size.

Both sources also make not of the differences in tax efficiency too. This much I get.

However, it's perhaps this whole notion of "same effect on shareholders' wealth" that I'm taking objection too. Namely, the glaring difference here, unless I'm missing something, is paper versus realized wealth. Dividends are cash out, reducing shareholder value, but giving the shareholder a realized cash flow. Meanwhile, share buybacks increase the share price but its only on paper. Not to labor the point, but suppose the buyback shortly preceded an index-wide downturn. That's essentially what I'm trying to probe for. The utility of realized gains to some investors seems to be missing from the discussions and textbook comparisons of dividends versus buybacks.

Question

Why isn't the realized versus paper dimension brought up during these comparisons? Or am I totally missing the point on something?

Answer 1

Who do you think share buybacks are buying the shares from? If you're a shareholder it's you!

You can sell all, or in some cases some of your shares back to the company. That's your cash dividend equivalent. If there's a downturn, well you have that cash just as if the company awarded a dividend.

The difference is that you usually don't have to participate in a share buyback so you can just keep your shares if you think they will still outperform. A dividend generally goes to all shareholders.

Answer 2

A dividend is not not free money. It is cash flow that moves money from one pocket to the other. This is because when the security goes ex-dividend, share price is reduced by the amount of the dividend. Your position's total value at ex-div is exactly the same as it was at the previous close with the exception being that if the dividend is received in a non sheltered account, the dividend is taxable.

A buyback is a bit more complicated. If we assume that the buyback occurs at the same time as the dividend then if you participate then you get equivalent value as above but more cash flow since you are selling the the security. Because of this, if non sheltered, you may owe taxes on capital gains from security appreciation.

With a buyback, the company purchases shares from shareholders, reducing the number of outstanding shares. This improves profitability metrics like cash flow per share and earnings per share. This tends to drive the share price higher over time, increasing capital gains which are not taxable until the shares are sold.

So if you do not participate in the buyback then you are foregoing the cash flow in return for an uncertain future return on which tax is deferred until the shares are sold. And as you noted, if there is a market downturn, your position may lose value and it may take even more time to break even, let alone realize that future benefit.