Buybacks vs dividends: Which is better for shareholders?

AT A recent Singapore Institute of Directors event, participants suggested that companies that have no better use for their excess capital should consider buying back their own shares.

This is an increasingly popular recommendation, and many companies have responded over the past few years by introducing buyback schemes. But is it necessarily best for shareholders?

The conventional argument for buybacks appears to be straightforward.

If a company earns S$100 million and has 100 million shares outstanding, earnings per share (EPS) is S$1. If it buys back 10 million shares and earnings remain unchanged, EPS rises to S$1.10, which is said to be positive.

However, nothing has really changed in the underlying business.

The company has not sold more products, improved its margins or generated an extra dollar of profit. Instead, there are simply fewer shares over which the same earnings are spread.

While the reality is that no additional economic value has been created, the company has actually depleted cash that could have been channelled to productive uses. An efficient market should be able to easily take this into account.

Supporters of buybacks would argue that this misses the point, because if the shares are truly undervalued, using surplus cash to repurchase them can be an excellent investment.

Granted, this argument has its merits. But this assumes that management is a better judge of the value of its shares than the market, which may not necessarily be true.

Note, too, that a company that buys back overpriced shares would end up destroying instead of creating shareholder value.

There is also a governance issue, because executive remuneration is often linked directly or indirectly to measures such as EPS or return on equity.

Both can be improved by reducing the number of shares or the amount of equity, so boards have to be careful that capital-management decisions are not being influenced by the performance measures used to reward management.

None of this means that buybacks are inherently undesirable; they can make sense if a company has surplus capital, few attractive investment opportunities and its shares are trading well below a conservative assessment of intrinsic value.

A better answer to surplus cash

However, there is an alternative which is considerably less complicated: paying the money to shareholders as dividends, since there is no pretence about what is happening.

The company has cash it cannot employ at an attractive return, so it returns that money to its owners, leaving them to decide for themselves what to do with it.

Shareholders can then reinvest it in the same company, invest it elsewhere or spend it.

More importantly, the benefits are transparent, which is vital in Singapore, where dividends have traditionally been a key component of returns and where many investors buy stocks precisely for passive income.

There is also an important distinction between the two methods. Dividends distribute cash proportionately to all shareholders, while a buyback pays cash only to those who sell.

Boards contemplating buybacks should therefore be prepared to answer a simple question: Why is buying back our own shares at today’s price better than paying cash to all our shareholders?

If there is a convincing answer – for instance, if the shares are clearly and demonstrably undervalued – then perhaps a buyback is justified.

But buybacks should not become an automatic response to surplus capital, nor should a mechanically higher EPS be confused with genuine value creation.