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Are stock repurchases a substitute for dividends?
With the stock market offering a paltry dividend yield, some market commentators have tried to make the case that the “yield” is much higher. One must not ignore the effect of stock repurchases. We don’t agree with this argument.
Managements have two means of returning cash to shareholders:
pay the cash out in the form of dividends. In this case, all shareholders receive the same amount of income per share.
use the cash to buyout shareholders who would like to sell. In this case, only the selling shareholders receive a flow of cash from the buyout. The company retires the shares of the selling owners. The remaining shareholders benefit in that they each own a greater percentage of the total remaining shares outstanding.
Some people argue that stock repurchases should be considered the same as dividends for the purpose of valuing stocks. For example, if a company has a $10 billion market capitalization and pays out just $100 million in dividends, the dividend yield is an unimpressive 1%. But if one were to include $500 million worth of stock repurchases as part of the “yield” then the “yield” might be five percentage points higher at 6%.
While we support the idea of a company buying in its stock at a price below its intrinsic value, we don’t like the idea of conflating stock repurchases and dividends for valuation purposes.
Management teams don’t declare dividends lightly. Stock market investors react very badly to reductions in dividends, so management teams tend to increase a payout if they have a great deal of confidence that they will be able to sustain the dividend over the long term.
In contrast, stock repurchases give management much more flexibility. A company can announce the intention to repurchase stock while leaving the timing of the repurchases uncertain. If corporate cash flows are insufficient due to company-specific or general economic conditions, the company can quietly delay or abandon its repurchase plan.
People who invest for income expect to be paid. Dividends represent a far greater commitment to producing income than a stock repurchase plan.
