Investment Fallacies: Dividends & Buybacks

Dear reader, A continuation of my series on Investment Fallacies.

Many stock analysts debate as to whether a company should use its cash reserves to issue a dividend, or to buy back their issued stock.

At its core, this is a capital allocation decision. A company should issue a dividend if and only if it believes that it can no longer make a supernormal return on such capital, and that that capital would be better off in the hands of its shareholders. In essence, it is an admission by a company that it can no longer profitably reinvest excess cash.

In some companies this is to be expected. For example, a company operating a gas pipeline would, after its initial Capex is recouped, hope to make stable long-term profits. These profits cannot be linearly reinvested, and would often be better off distributed back to its shareholders as as dividend. This may also be the case for many REITs, and other infrastructure-related investment companies. For all other companies, however, a dividend that increases over time can be seen as a negative sign vis-à-vis a company’s future growth prospects.

There is nothing wrong with admitting as a company that you no longer believe that you can (in the current market environment) profitably reinvest excess cash. It is honest. But investors should be careful about evaluating a company based purely upon its “dividend yield”, and panicking if that “fixed” dividend yield changes. Those investors should buy bonds instead.

If investors want to generate yield from a company generating strong profits, they can always sell an equivalent amount of stock, thus generating themselves a “dividend” at will.

Likewise, I have never understood the debate over whether or not a company should use its excess cash to issue a stock buyback. Some companies claim that they carry out buybacks to “prevent dilution” due to, say, issuing stock options to its executives. Others say that they will undertake a buyback to “increase the value of the stock”.

A company should only buy back its stock if it believes that its stock is fundamentally undervalued. It is, in essence, betting on itself, converting its free cash reserves to equity capital. At the point of the buyback, a company’s value will be identical, regardless or whether it has more or less shares outstanding.

As with issuing a dividend, a company is saying that they do not have any other productive avenues to reinvest their cash, and thus are choosing to undertake a buyback instead.

To be fair, one potential purpose of a stock buyback is to raise the stock’s financial leverage. Despite the standard assumptions of finance theory, we all know that it is not always so easy for companies to borrow money. Furthermore, performing a stock buyback can sometimes be seen as a sign of confidence by the company: that it indeed believes that its stock is undervalued.

Yours Sincerely,
Henry Chong