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Are Buy-Backs on a Rising Market Always a Bad Move?

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In an article in the Financial Times, “Buy-backs on a rising market are always a bad move” on Monday, June 13, 2011, Tony Jackson made the argument that share buybacks are a failed strategy because companies are buying back stock more frequently when stock prices are high than when they are low. He framed the argument in terms of recent actions by ExxonMobil to use stock to buy XTO Energy last summer and subsequently to increase its buyback program. He stated “Logically, the first action made sense only if Exxon thought its stock was over-valued. The second made sense only if it thought the opposite.”

This argument is common and flawed. Put most simply, imagine that the stock was perfectly valued. Exxon might have found that shareholders of XTO preferred a stock-for-stock exchange for tax reasons and Exxon was indifferent; thus a stock-for-stock exchange was appropriate. After the transaction, Exxon had more cash available than it required for investment having chosen to issue shares, so it repurchased shares, partially neutralizing the increase in outstanding shares created by the purchase transaction.

Companies periodically find themselves with cash that exceeds their internal needs for investment and face a choice about how to distribute the excess funds to shareholders. One pathway is dividends. The other is share buybacks. Each has its strengths and weaknesses and the proper question for analysts to ask is under what circumstances each is better.

Dividends have the advantage of affecting every shareholder equally. Each shareholder receives the same proportionate distribution. Markets have viewed dividends differently through time, but one common view is that regular dividends give proof to the long-term cash flow generating ability of the company. Financially strong companies with excess cash pay dividends regularly and an increase in dividends signals their long-term strength. Much of the long-term return to equity ownership over recent decades has resulted from dividends. And yet, dividends come at a cost. Once initiated, their reduction or termination is a major negative signal and damages share prices significantly. So dividends are typically initiated or increased only when the ability to maintain them or increase them is somewhat assured.

Baruch's MS in Financial Statement Analysis and Securities Valuation

On the other side of this argument is the notion that no companies should pay dividends when they have opportunities for high net present value investments. Under this view paying or initiating a dividend signals reduced growth opportunities. This issue was embraced by the high tech companies in the latter part of the last century when dividend payments were scarce in the whole industry. After all, growth stocks didn’t pay dividends.

Today, on average across all industries we find American corporations holding huge cash balances. What will they do with the excess cash? They have multiple choices including buying other companies, investing in R&D, making other capital investments, and distributing their excess to shareholders as dividends or share buybacks. Years ago there were tax reasons to favor buybacks because capital gains were tax preferred over dividends. That is not currently true.

So today, if the company chooses to return capital to investors, the choice of dividends versus buybacks is largely tax neutral. Buybacks are slightly better because only the gain is taxed to shareholders. Buybacks are also flexible. They do not continue indefinitely; in fact even the full scale of an announced buyback need not be executed, and their timing is fluid. In addition, buybacks have the advantage of inducing selling by the shareholders least enthusiastic about the future of the company. Those inclined to maintain their investment experience an increase in the value of their holdings without explicit tax implications.

To clarify the last two observations, let us run a thought experiment. Assume dividends are paid. The value of the firm declines by the amount of the dividend, and the effect is felt pro-rata by the shareholders. Each shareholder has a taxable event, unless the shares are held in a tax-exempt form. Assume that the same dollar amount is spent in repurchasing stock. Those who want to sell do so, and the other shareholders do not. The total value of the firm is the same as it would have been if the same dollar amount was distributed in dividends, but since the number of shares is reduced the value per share of the remaining shareholders increases.

If the best choice facing the company is a distribution of cash to shareholders, the only question is its form, i.e. dividend versus share repurchase. The answer depends on the future plans of the firm, the reliability of repeated and increasing distributions over time, the existing tax environment, etc. The argument that repurchase is prima facie wrong if the future stock price declines is wrong. Whether the cash payout was dividend or repurchase, the future assets in the firm and its total value are the same. You do not want your companies to be making choices about dividends versus share repurchase based on their assessment of the stock’s value. Sometimes a future decline in share value is a result of a firm-specific error and sometimes it is the result of market-wide crisis (think 2008–2009). Mr. Jackson noted that companies buyback more shares when markets are good and prices are high but he would also probably find that companies pay more dividends when markets are good and prices are high, and that they make more ill-advised mergers and acquisitions as well.

John Elliott, Vice President and Dean, Zicklin School of Business, Baruch College, City University of New York

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Thank you Dean Elliott, you explained dividend versus repurchase in such a simple way that all non-financial folks can appreciate it too.

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