When we invest, it is generally to benefit from either capital growth or income. In the case of shares, that income is provided by way of a dividend payment. How the payment of a dividend benefits us as shareholders is pretty straightforward to understand, but when a company  decides to use its cash to purchased its own shares, rather than distribute that cash to shareholders, it’s rather more difficult to see the benefits (if any).

Before I answer the question posed in the title of this article, let’s have a brief look at stock repurchase schemes in a little more detail.

What is a stock repurchase?

Stock repurchase schemes, also called share buybacks, are a method of a company buying back its own shares. It can do this in one of two ways: either requesting its shareholders to tender their shares at a fixed price, or by direct purchases made from the stock market.

Of course, the company can’t just decide one day to buy back its own shares: permission to do so has to be sought at the annual general meeting, at which the conditions of the repurchase program will be set. Such condition will include the amount of the share repurchase program – either expressed in terms of total value or numbers of shares – and the period during which share purchases can be made.

Any shares repurchased through such a program are cancelled by the company.

The reasons to conduct a share repurchase scheme

Returning value to shareholders can be achieved by either providing capital growth, or by paying a dividend. But let’s say that a company believes its shares are poorly priced by the market, and the share price does not represent the true value of the company. In such a case, it may be prudent to buy shares in the market. This has the effect of adding demand and helping to push up the share price – that’s part of the theory.

If the company has announced the price at which it will be purchasing its shares, then this often has the effect of putting a baseline under the stock: until all shares under the scheme have been purchased, then a buyer will always be seen at a certain price. The forming of an absolute bottom in the share price is easy to understand (if there is a buyer at $1, a shareholder wouldn’t want to sell at 95 cents). Understanding how a buyback scheme can help the stock price move forward is a little more complex.

Related: How to Pick Good Dividend Stocks

Helping the share price rise?

Firstly, if you consider a company’s value as being a liquid amount of cash – all of its property, products, investments, etc are all held in one account as a big cash fund – then it is easy to think about the paying of a dividend or the buying of shares to have exactly the same effect on the company’s value. Doing both takes money out of the cash pile, and so cuts the value of the company.

In the case of the payment of a dividend, however, the cash paid out can never be returned. It’s gone, forever. And after the fact, the same shareholders are left sharing the balance of the value of the company, and its future dividends.

It’s also true that once the company has repurchased its shares, that money can never be returned: the shares are cancelled. Now the value of the company has fallen, but this value is shared by fewer shareholders – as are future dividends. The share of the remaining value and future dividends has increased for the remaining shareholders.

So even though the value of the company will have fallen, the share price may rise because there are fewer shares outstanding. Future per share dividend payments may increase, and this will be another booster of share price.

Does this mean that share buybacks are always a good thing?

A company will conduct a share buyback because it believes its shares are undervalued, and by doing so it will give shareholders a better return than through a dividend or inward investment.  But this doesn’t mean it is a good way of returning value to shareholders: after all, price and value are entirely different animals.

When examining whether or not a stock repurchase is good for the investor, calculation of investment ratios such as price to earnings and earnings growth should be conducted as well as consideration given to revenue, debts, and cash flow.

The bottom line is that if the investor believes the share price is below a reasonable valuation of the company, then the share buyback will be working in the shareholder’s interests.

Related: Is There Still Room in Dividend Stocks?

Don’t forget tax!

Another potential advantage to shareholders of a share buyback, is that the hoped for increased value to shareholders is given as a capital gain (rise in share price) rather than as income.

Capital gains are taxed at the marginal rate, but only on 50% of the gain. There is a potential tax advantage here, though of course this would depend upon individual circumstances.

But, what can be stated for absolute assuredness is that the capital gain is not taxed until it is realized, and this means that the choice of when to pay the tax on the gain is a matter for the investor – only when he sells his shares will tax become liable. That is a degree of control given to the investor that the paying of a dividend takes away.

Are there any disadvantages of share buybacks?

If the company had used its cash to pay a dividend, perhaps increasing that dividend, then how that cash is used by the investor is at the sole discretion of the investor: it is his/her choice. Buying and cancelling its own shares means the company is removing this level of control from the investor. Even if the investor would have used his dividend to reinvest, when and at what price would have been his decision: effectively, by repurchasing its own shares, the company has decided to reinvest for the shareholder.

Share repurchases take cash management choice away from the investor.

Answering the question

At the top of this article I posed the question is a stock repurchase or payment of a dividend best for the investor?

When a company buys back its own shares under a share buyback scheme, the share price should react positively and future dividends per share increase. The share buyback also means that the investor has more control over how much tax he will pay and when.

However, for those investors that want or need the income produced from dividends, then a share buyback scheme does not meet this requirement (certainly in the short term). It also removes the flexibility of choice of what to do with the dividend, whether to reinvest and when and at what price, or to spend or invest elsewhere.

In summary, the answer to the question really depends upon individual investment aims and requirements and the investor’s valuation of the company. Maybe a better question to ask oneself upon the announcement of a share buyback is ‘would I buy shares at this price?’ If the answer is ‘no’, then perhaps the investor should consider selling his shares to the buyer that believes the company is undervalued.

Michael Barton

Michael Barton

Michael Barton has a career of 25 years covering global financial markets. Having worked for companies large and small, trading and advising on assets from equities to derivative products, Michael now writes about the opportunities and markets that matter to investors. He contributes content to several keenly followed investment blogs and websites.