Why do companies pay a dividend when they can buy back and retire shares to increase their share price?

Question

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?

Answer 1

Paying a dividend vs buying back shares is, from a pure financial theory perspective, the same thing from a corporation's perspective. In either case, the Corporation has cash, pays that cash out, and reduces their Shareholder's Equity account.

The 3 things that complicate reality from theory, are:

1. Tax ramifications: Share buybacks may result in shareholders choosing to sell, to have a gain or loss on that sale. Dividends being paid may create taxable dividend income for all shareholders. There are tax pros and cons for each scenario, depending on jurisdiction and specifics of each shareholder.

2. Transaction costs: Shareholders may suffer [relatively trivial] transaction costs for sales compared with dividends [or, they may suffer transaction costs of reinvesting their dividends into more shares]. The organization itself may suffer additional transaction costs to validate the appropriate buyback price and volume to ensure successful transaction [ie: per answer from Littleadv below, the price needs to be attractive enough for the order to be fulfilled, hopefully without being too much higher than the market price on that day].

3. Technically after a buyback, there are fewer nominal shares outstanding, each with a slightly higher price. This is generally a trivial effect because the actual "price per share" itself isn't a tangible reflection of anything except "value of company in the market's eyes per latest share sale, divided by number of shares". This may in theory change someone's perception of value if the number of shares change, but only if they misunderstand what it means.

Note that from a shareholder's perspective, receiving a dividend does not mean you need to reduce your compounding investment in that company - you could choose to reinvest dividends back into more share purchases.

Answer 2

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.

No. Dividends do not usually inflate the value of the stock. In fact, the stock share prices usually drop on the ex-dividend day by the dividend value.

Most dividends seem to be around the 5% range

Also no. And 5% of what anyway?

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Dividend is actual money distributed to shareholders from the company profits. When company distributes dividends - shareholders receive cash. This is important, since receiving net income is one of the reasons people own things. Many people rely on dividends as their revenue stream. Many retirees essentially live off of the dividends, many wealthy people also.

Since it is money being actively distributed by the company, dividend distributions affect the company value and it goes down by the amount distributed (simple math). As the result, share values also go down when dividends are distributed.

Share buy-backs do not change the value of the company or distribute money to the (remaining) shareholders. Share buy-backs result in overall valuation remaining the same, but spread over less outstanding shares - raising the value of each share. But that increase in value is on paper only, it doesn't translate to actual cash to the shareholders (except those selling their shares to the company). As such, from a shareholder perspective, share buy-back may increase the value of the remaining shares but doesn't affect the shareholder cashflow.

For share buy-backs to work, some shareholders need to actively sell their holdings. Most times it results in companies buying back shares at inflated prices, which is actually a net negative for the remaining shareholders and a benefit for the few participating in the buy-back.

Most retail shareholders (individuals) would prefer dividends over buy backs, while most institutional shareholders, wealthy speculators, and funds would prefer buy-backs as they're the main beneficiaries of the system. Unfortunately the latter are much more influential in board rooms and shareholder meetings than the former.