The Contrarian Case For Stock Buybacks

September 06, 2016

There is no shortage of articles criticizing corporate America for buying back so much of its own stock.

According to the New York Times, these articles have dispelled the illusion of stock buybacks. Yet they only provided a few examples of individual stocks, and managed to ignore the fact that the PowerShares Buyback Achievers ETF (PKW), holding hundreds of stocks, handily bested the total return of the S&P 500 since its launch in late 2006, in spite of expenses.

To see why buybacks can be better than dividends, let’s take an imaginary case and a very simplified scenario where dividends would only be paid once a year.

Chart courtesy of StockCharts.com

 

Dividends Or Stock Buybacks?

Say one year ago, you bought 100 shares of “Shareholder Value Inc. (SVI)” for $45 a share. It performed well and now sells for $50 per share. So your $4,500 investment is now worth $5,000. SVI earned $4 per share and has determined it can only invest half of the money to earn more than the rate demanded by shareholders (its cost of capital). Thus, management wants to do the right thing and return $2 per share to its owners. It knows it has two options—dividends or stock buybacks.

If SVI pays you a $2-per-share dividend, you will pay dividends taxes on $200, typically at 15% plus state taxes, which amounts to $30 in Federal taxes. The price of your stock will immediately fall by $2 (as it no longer has the cash), and you will own 100 shares at $48 per share, or $4,800 of stock, and have $200 in your pocket before taxes.

 

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