There’s a surprising amount of misleading writing about capital distribution, and in particular the issue of dividend vs. share repurchase. In this post we’ll examine some common canards.
Confusion in the Popular Press
The popular press regularly sings the praises of dividends vis-a-vis share repurchases, proposing various arguments along the way. Several themes are commonplace:
- Investors are fooled by EPS impacts. A trade which increases EPS without altering the firm’s fundamental value tricks investors: “buy-backs . . . create the impression that the group has added value“. BusinessWeek suggests an ulterior motive to Exxon’s recent buybacks: “They don’t need to grow production in order to generate shareholder returns.” Taken to its logical conclusion, buybacks are to be avoided because they lead to “a short-term illusory benefit from having fewer shares in issue”; upon regaining their faculties investors will pull the price back down to fundamental value. In contradistinction we find that the marginal investor (as opposed to, say, index-fund investors, who make no discretionary trades) is typically a professional investor, and is comfortable with the algebra required to account for the impacts of equity issuance or repurchase on share-count metrics (such as EPS).
- Capital returned via dividend is higher quality. For example: “If it becomes the norm for most firms to pay out a large chunk of their profits as dividends, companies posting fake results might not get away with it for as long.” Or “Investors benefit more [than with repurchases] when executives spend money on equipment to fuel corporate growth or pay out dividends.” This argument suggests that management should set as large a regular dividend as they feel comfortable maintaining, and resort to alternative mechanisms only for distributing residuals; therefore higher dividends demonstrate greater sustainable earnings. As we’ve noted elsewhere however, companies have ceased relying on dividends as signalers of earnings prospects, and recent practice finds firms distributing only the minority of retained earnings through dividends. We conclude that management views investors as increasingly capable of independently assessing earnings quality, and decreasingly relying on the historical importance of dividend level.
- Share price doesn’t matter. Despite the ongoing decline of dividends, a minority of advisers appear wedded to the belief that corporations reify earnings in only this way. The Economist, for example, recently chastised investors for focusing on earnings instead of dividend yield. At QCF we value investments using economic measures, such as total shareholder return, which comprehensively measure wealth creation. Under such measures, the form of distribution doesn’t alter returns; for a worked demonstration, see here.
- Investors prefer dividends to share repurchases. In 1980, perhaps; today, they do not. (The linked paper discusses institutional investors, who compose the marginal investors in most equity issues these days.) The return of capital via dividends has been in secular decline ever since the SEC gave the green light to share repurchases in 1982. (See our earlier post on this topic.)
- Buying back “overpriced” shares destroys shareholder value. For example: “A buyback is bad when shares are overpriced. If you don’t know the value of your stock, it’s really simple; you just pay a dividend. I know plenty of companies that bought back shares and found out a year or two later that they would have saved a lot of money by waiting.” This argument suggests that assets have an inherent, observable, and widely agreed-upon value; and that prices will fluctuate around that value. Recent events have cast doubt on this version of the efficient market hypothesis (which equates price and value) and the assumption of homogeneous investor expectations. The fundamental confusion here might be over the word “buy”: unlike regular asset acquisitions (which leave the net asset level unchanged), cash-funded share retirement reduces the level of assets and in fact moderately reduce earnings through foregone interest income. A share buyback doesn’t “buy” anything that an equivalent dividend wouldn’t. A comparison between price and value of a firm’s shares isn’t useful to capital return discussions.
- A company can create value by timing its equity repurchases. Management may feel pressure to time equity transactions. “Given where our price is in the marketplace, we always look at buybacks,” Disney Chief Financial Officer Jay Rasulo said at a conference on Sept. 21, 2011. BusinessWeek comments “Executives have faced criticism from shareholders and analysts in the past for launching buybacks when stock prices were high.” This perspective assumes the goal of capital return is to maximize long-run EPS: capital return should occur not when the firm holds capital in surplus (typically, when earnings are high); instead firms should hoard cash until share prices fall. Of course the requisite crystal ball doesn’t exist, and a firm attempting to time repurchases risks penalizing investors (at the cost of equity) while it awaits the starting gun of a dip in share price. (This may contribute to shareholders’ discounting of retained cash, on average by 6%.) It is difficult to overstate the importance of this point: hoarding capital incurs a real, quantifiable economic cost for investors which usually outweighs any benefits from tweaking accounting measures. Instead of anticipating market vicissitudes, firms should follow Standard & Poor’s advice and “engage in share repurchases only when they have strong cash flow and when internal projects are insufficient to generate a comparable rate of return”.
- Share repurchases only benefit disinvestors. The assumption is that upon announcement of a share repurchase, investors who believe in the firm will forego the offer and thus will not benefit. We find this logic uncompelling. From an economic perspective, distribution form is irrelevant; this holds regardless of whether an investor surrenders her shares or not. From a market dynamics perspective, shareholders always have the option to retain or sell their holdings; the temporary addition of a new bidder for the shares (the issuing firm itself) doesn’t alter the shareholder’s options.
The last few decades have seen tectonic changes in the makeup and behavior of equity investors. The marginal investor today is a sophisticated institutional professional; she takes advantage of the increasing visibility into a firm’s operations and performance to derive her own assessment of the quality and trajectory of earnings. She is less sensitive to metrics such as EPS and increasingly interested in the management of capital as a scarce resource. A firm better serves this type of investor not by spending time determining whether its shares are overpriced; instead it determines whether it’s holding surplus capital.
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