Directors at profitable corporations must choose between retaining cash for future growth, retiring outstanding debt, or distributing the excess cash to the owners (shareholders).
If they choose to distribute the cash, they also have to decide if dividends or share buybacks are the best method. From a utility standpoint, both buybacks and dividends are equal in that they serve the same purpose of distributing the free cash.
So, why do companies choose one over the other? Buybacks maintain corporate flexibility. When a company initiates one, the company controls the time line of the purchases, if they happen at all.
Many times, announced repurchase plans are not completed or executed. Dividends are perceived by investors as being more permanent than share buybacks. As a company’s dividend grows, so do investor expectations of the company. Corporate leaders fear not being able to maintain a high dividend policy because the market delivers a harsh penalty to the share price in the aftermath.
Another reason companies prefer buybacks the reduced number of shares outstanding supposedly boosts the company’s earnings per share.
This improvement is superficial because it does nothing to improve the firm’s balance sheet or win it more market share. It is the equivalent of taking money out of your right pocket, placing it in your left pocket, and then suggesting somehow you are now richer.
Buybacks are also common when a company’s stock is perceived to be undervalued.
Perhaps a bit cynically, stock buybacks do have a direct impact on management’s long-term incentive compensation. The value of stock option based compensation depends on an increasing share price.
Management teams holding options do not share in the dividends paid by the company but they certainly benefit from the increased value reflected by a rising share price.
Dividends are the most consistent component of total return and should be weighed more heavily than buybacks in assessing a company’s ability to create and distribute wealth to its owners.