Buybacks versus dividends – which is best?

The good things about dividends

Dividends are simple to understand. They are a proportion of a company’s profits paid out to shareholders. Most UK companies paying dividends will pay them twice a year, with some paying them every three months. Sometimes a company will pay a special, one-off dividend from profits that have not been paid out from previous years.

The great thing about dividends is that they represent a tangible return from owning a share. Once a dividend has been paid out it cannot be taken away from you. The same cannot be said for increases in a share price.

Reinvesting dividends and buying more shares with them is an excellent way of utilising the power of compound interest to build up your wealth. Done over a long enough time period, dividend reinvestment can deliver great results and generate a significant stream of growing income from a shareholding with very little effort.

One drawback of dividends is that they can limit the ability of a company to invest in very profitable projects. If a company has the opportunity to invest money at high rates of return, then retaining profits in the business – rather than paying them out as dividends – and reinvesting them can create more value for shareholders over the long haul. 

The murky world of share buybacks

It’s always worth reminding yourself how you make money from owning a share in a company. Financial returns can only come from two sources:

Return from a share  = Change in share price + Dividends received

Share buybacks only work for shareholders if they boost the share price – something that the stock market can easily take away. You could be forgiven for thinking that company managements, professional analysts and the financial media believe that buying back shares is universally a good thing. It is not that simple. Share buybacks are one of the most controversial and misunderstood topics in finance.

Quite often share buybacks give a much better deal to the company and its management. Shareholders are often left scratching their heads trying to work out how and if they are any good for them.

What are share buybacks?

A share buyback is where a company buys its own shares on the stock exchange and cancels them to reduce the total number of shares in issue.

The justification for share buybacks can seem very powerful at first glance. By reducing the number of shares in issue a company can spread its profit across a lower number and increase earnings per share (EPS). This might then allow it to pay a bigger dividend per share as well, which would be a positive.

As lots of people value shares using price/earnings (PE) ratios, a higher EPS can lead to a higher share price too. This because the higher EPS after a buyback can lower a PE ratio and make the shares look cheaper than they were before. This attracts buyers who can push the share price up.

As some investors prefer capital gains to income from a tax point of view (because they are taxed more favourably), surely share buybacks are a win win for everyone? Not so fast. A higher EPS does not always mean that a company has become more valuable.

Share buybacks have been growing in popularity in recent years – particularly in the US – and have been seen as a major reason for why shares have performed well since the financial crisis. Instead of using their cash flows to invest in new projects that can increase a company’s profits, many companies have been buying their own shares instead.

The share prices of many companies that have done this have gone up a lot in the short run, but time will tell if this is money that has really been spent well.

The investor and share buybacks

What does a share buyback actually mean for you as a private investor? The cheerleaders of share buybacks tend to overlook one crucial and important point – the price paid for the shares when they are bought back.  Remember, all investment is about getting a decent return on your money. Increasing EPS by buying back shares doesn’t necessarily mean that you are doing this.

Let’s have a look at how a share buyback works out in practice by looking at some numbers of an imaginatively named fictional company called Buyback plc.

Buyback has built up a very successful business over the years. It is making a very respectable £100m of trading profits every year, but stiff competition means that this number is unlikely to change much in the future. The stock market is in buoyant mood, though, and has given the shares a very punchy valuation of 160p a share, or £1.6bn, or 20 times earnings (a PE ratio of 20) despite the low or non-existent growth prospects.

Buyback needs to keep its shareholders happy. Its advisers suggest buying back 10 per cent of the existing shares (in this case 100m of them) in issue so that EPS can keep growing. So instead of paying a dividend the company decides to use the next two years’ post-tax profits (£160m) to buy back shares at the price of 160p each instead. But will this make his shareholders any richer? More on this shortly.

The management of Buyback are pleased. Even with no growth in profits, EPS has increased by 11.1 per cent as shown below.

Using spare cash to buy back shares

Company executives like share buybacks because more often than not their bonuses are linked to EPS growth. They are also really handy at offsetting new shares that have been issued for bonuses and share options. A company’s stockbrokers often encourage them because they can charge commission on all the shares bought back. Paying special dividends is not a money earner for them.

Fast forward a couple of years and Buyback’s shareholders are not happy. It turns out that the shares were not worth 160p at the time. They were overvalued at this price because of their low growth prospects. They are now trading at 80p each  equivalent to a PE ratio of 9 on the higher EPS. The £160m spent on a share buyback has been a huge waste of money. The lesson here is this: Share buybacks only make shareholders better off if the price paid for the shares is less than the company is actually worth.

So what Buyback was doing was paying 160p a share for a business that was only really worth 80p a share (8p of EPS x PE of 10 before the buyback). In doing so, it reduced the true underlying value of the business to just over 71p, as shown in the table. If it had paid 75p then it would have increased the value of the business. The effect on EPS is irrelevant. By paying too much, Buyback has destroyed a large chunk of shareholder value just as many company managements do in the real world.

Buyback plc

Spending cash on buying back shares reduces the total equity value of the business (because you have less cash than you would have done if you had retained it). Value per share goes up if the business value shrinks by less than the reduction in the number of shares. You can only do this by buying back shares for less than they are worth.

Of course, value is a matter of opinion. However, instead of paying over the odds for its own shares, Buyback could have spent the £160m on a special dividend of 16p a share. Instead, shareholders have made no gains.

The Next approach to share buybacks

One of the best ways of checking out the merits or otherwise of a share buyback was set out by fashion retailer Next (NXT) in its 2012 annual report. It looks at what it calls the equivalent rate of return (ERR) – the return the company would need to get on an alternative investment to achieve a similar increase in EPS from buying back its own shares.

The company also set out some commonsense rules for doing a share buyback:

• It must enhance EPS.
• Only use the spare cash that the company does not need.
• Use surplus cash, do not take on extra debt.
• Keep paying a dividend and try to increase at least in line with the increase in EPS.
• It must earn an acceptable ERR. Next had a target ERR of at least 8 per cent.
• Do it regularly.
• To work well, the company must have decent long-term growth prospects.

The slightly complicated bit is working out what it calls the ERR. Thankfully, this is not too difficult to do.

Most people can understand interest rates and that a high interest rate is better than a lower one when it comes to investment returns. This is what makes Next’s explanation so useful, as hopefully you will see. Let me explain how it works.

To work out the ERR of a buyback you need four pieces of information about a company, all of which you can find on the internet.

1. Its share price.
2. The number of shares in issue.
3. The amount of money to be spent on buying back shares – this can be any number you want or the number that the company has mentioned.
4. Its latest annual or forecast pre-tax profit.

The calculation for Next at its current share price and forecast profit for a £300m buyback is shown in the table below. It shows the equivalent increase in profit needed to increase EPS by the same amount as a buyback. That extra profit is divided by the cash spent on buybacks to get the ERR.

Next ERR from buying back shares using spare cash

Source: My calculations/Next 2012 annual report/SharePad

It is telling us that if Next spent £300m of surplus cash (not borrowed money as the extra interest costs will give a different result) buying back its shares at £52.04 each it would give an equivalent rate of return of 10.6 per cent. In other words, a buyback at the current share price delivers a respectable rate of return and is not harming shareholders.

Buyback plc equivalent rate of return

If we return to our fictional company Buyback we can see that its ERR is 6.9 per cent. This would be below 8 per cent and suggest that the buyback is not a good use of money as was shown earlier.

But are high equivalent rates of return a guarantee of superior shareholder returns?

Have share buybacks worked for Next shareholders?

Source: Company reports/Capital IQ

Next has been buying back its shares every year for almost 20 years, and long-term shareholders have done well as profits have increased and the number of shares has shrunk. But in the past five years, total returns to shareholders have been effectively zero despite spending £921m (roughly £6 per share on the 2015 share count) on buying back shares.

Next total shareholder returns 2014-19

Source: Company report

So despite enhancing EPS and delivering acceptable ERRs, Next’s buybacks have not worked for shareholders in the past five years. So what’s been the problem?

As is often the case when it comes to investing, it all boils down to growth or the lack of it. Pre-tax profits have come down from a peak of £836m in 2016 and are expected to be £727m for the year to January 2019. Shrinking the number of shares has propped up EPS and stopped it being lower than it otherwise would have been.

You could argue that the buyback has stopped total returns being worse as EPS enhancement may have prevented larger share price declines. That said, the £6 that could have been paid out in special dividends could have been a better use of surplus cash.

As I wrote a couple of weeks ago about quality shares, without growth they can be poor investments. The same seems to apply to share buybacks. Without growing profits as well, do they do much good? In fact, successful investing in shares in general is all about growth in my opinion.

WH Smith: buybacks with profits growth – a much better mix

Source: Company reports/SharePad

WH Smith has proved to be a different kettle of fish. It has shrunk its share count while growing its profits. The buyback may not have earned as high ERRs as Next, but it has given an extra boost to EPS growth and helped to deliver excellent total shareholder returns.

WH Smith total returns 2013-18

Source: Company reports/SharePad

Clearly, many things help to drive a company’s total shareholder return, but if buybacks are being used as a way of boosting them, growing profits are needed as well. WH Smith passes this test with flying colours in the past five years but Next has not.