A share repurchase, or buyback, occurs when a company buys its own shares on the open market. A dividend is corporate profit distributed to the shareholders. Since both can only be done with corporate profits, which belong to the shareholders, a share repurchase and a dividend are two forms of returning profits to the shareholders. But their net effect can be markedly different.
Enhancing Shareholder Value
A share repurchase and a dividend are two of the several forms of enhancing shareholder value. A company can enhance shareholder value by either pushing up the stock price or generating investment income for investors. A share repurchase can push up the stock price by increasing per-share numbers such as earnings per share (EPS) and reducing the number of shares outstanding, which makes the stock more valuable and harder to buy. Dividends, meanwhile, allow the company to share profits with its shareholders.
A cash dividend is effectively taxed twice: first at the corporate profit level, then at the individual shareholder level when the dividend is paid. A share repurchase is not taxable to the shareholders and is a more tax-efficient way of using corporate profits to enhance shareholder value.
Using $1 per share in profits to buy back stock has a different net effect than paying out the same $1 per share of profits in dividends. If an investor receives a $1 per share dividend and pays 15 percent income tax on it, he gets to keep 85 cents. A share repurchase may produce a greater net benefit but is less certain. The same $1 in profits spent on a share repurchase may push the stock price up $2 or $3, or have little effect on it.
When deciding on how best to return profits to the shareholders, companies must take into account their shareholder base. Different shareholders own different stocks for different reasons. For example, conservative, income-oriented investors buy stocks for current dividend income. Even if a share repurchase would have a greater net benefit, they prefer a dividend because it is cash in the pocket. Growth investors, on the other hand, would rather see their stock’s price go up than collect a dividend they do not currently need.
- “PassTrak Series 7: General Securities Representative License Exam”; Dearborn Financial Services; 2003
- “One Up on Wall Street”; Peter Lynch; 2000
- “How to Make Money in Stocks”; William O’Neil; 2009