I am trying to determine something a bit niche that may not have an answer. I have asked professors, financial advisors, and random people. The best answer I have gotten is "I do not know, maybe there is a legal reason?"
On the surface, this appears in every way to be better than a dividend. Can you help me understand what I am overlooking?
The basics of a dividend:
A dividend is company money paid to share holders which inflates the value of a stock for a short (a few months.) period of time. Most dividends seem to be around the 5% range. This does increase the value of the company on paper, but it continually needs to be paid out to keep the value of the stock inflated.
So, the short term gain of stock value seems like a bad investment. I was trying to figure out if there was a better way to do this, which is where buying back and retiring shares to increase the share price seems like a good idea.
Buying back and retiring:
IF a company were to buy back shares and then retire them, the share price should increase. The company is worth $100, there are 100 shares, therefore the price per share is 1. [$100 / 100 shares = $1 /share]
If a company spent the same 5% that they would have spent on paying a dividend and bought back and retired 5% of the shares, the equation becomes. [$100 / 95 shares = $1.0526 / share]
So, each share retired is worth slightly more than the 5% you would have received if a dividend were paid.
- That assumes an ideal market, with investors who are rational. Obviously not guaranteed to happen. -
So, why would this be better than a dividend?
Firstly, $0.0526 > $0.05. A larger "dividend" would be better than a small dividend.
Second, you can realize the profit in the future as opposed to today. If you expected part of your portfolio to fall next year, you could wait to realize profits on this "dividend" until the next financial year, thus avoiding some taxes. (In a completely legal way.)
Thirdly, most boards of companies own a large percentage of the companies shares, this increases their holdings. (So, boards of companies should like this, as opposed to dividends.)
Fourthly, and most importantly. Assuming that the company experiences growth on par with the market average, the ability to not realize profits until the final year you hold and sell the stock should increase your final profits as opposed to receiving a dividend annually and reinvest those profits into the company because you would be earning profits on money that would otherwise be taxed prior to being reinvested.
Most Americans are long term investors. (15~20 years) They would prefer to throw money into a stock for 15~20 years with a 5% increase in annual value, as opposed to receiving a dividend annually, having to pay tax on it, before putting that same dividend back into the same company.
In summary, everyone wins IF the practice of buying back and retiring shares actually worked.
The company sees the share price increase permanently. (Assuming quite a bit here, a stable market, consistent growth, etc.) The board has greater control without having to spend their own money. The average investor sees greater returns. Investors can make more money by realizing profits in years when they make financial losses in other areas.
Can you tell me where I am wrong, if it was correct, I would assume that it would be done more often.
If you can, can you point me to any resources which could help me understand why this does not work?