Investing in a share of a company is to own a slice of the company’s business. Although it sounds obvious, when investing in the stock market, the goal is to invest your funds in a well-managed firm that can provide, ideally, positive future prospects. The company then invests shareholder cash to provide a higher rate of return compared to what the shareholders can generate themselves.
There are various ways in which companies reward their shareholders for their investments. This article explores three of the most common methods: dividends, share buybacks, and re-investing in growth.
What are dividends?
Dividends are cash distributions to the shareholders. Typically, dividend distributions happen once per quarter. The total amount is usually a percentage of the company’s expected long-term earnings. For example, since 2012, Apple has increased its quarterly dividends per share to $0.23. Considering that the share price of Apple as of this writing is $155.09, this translates to a dividend yield of 0.59% per share.
Who determines how much dividends to distribute?
The company’s board of directors determines both the amount and date of payment. When a company declares a dividend, it also sets an “ex-date,” after which the stock is traded without the value of the upcoming dividend payment. To take advantage of the dividend, the investor must hold the share until the ex-date. For example, Apple had an ex-date of February 2, 2023. After which, purchasing its shares would not offer any dividend on the payment date of February 16, 2023.
Once a company commits to dividends, it sets a precedent and is often irreversible. This is because:
- Canceling or reducing them may signal to investors that the company is in financial trouble or may not perform as well as expected.
- Some companies are added to certain ETFs or invested in by certain institutional investors (such as pension funds) because these companies distribute dividends. If they stop distributing dividends, these investors may liquidate their positions in the company.
As a result of the above, the company’s share price may decrease if they stop paying dividends. Case in point, look up what happened to Intel – the company cut its dividend to preserve cash. Its share price declined significantly after the announcement. Therefore, it’s very difficult to reverse dividend commitments.
What kinds of companies give out dividends?
Typically, mature companies give out dividends. Mature companies have reached a stage where their business is more stable. They can return the excess profit as dividends rather than re-investing in the business. In contrast, younger companies are less likely to pay dividends than mature ones because they usually are more focused on investing in their growth and development.
How are dividends taxed?
For the investor, dividends are not free from taxation. When a company pays a dividend to its shareholders, it essentially distributes a portion of its profits to them. As a result, the income earned from dividends is subject to taxation, just like any other form of income.
What is share buyback?
A share buyback is another way companies can return excess profits to shareholders by using cash to buy back shares from the public. To understand how this helps investors improve their returns, let’s start with some basics. Here is the equation for a company’s valuation.
- Share price equals market capitalization divided by the number of outstanding shares.
- All else being equal, typically, a company’s market capitalization remains unchanged if there’s no change in business prospects, macroeconomic conditions, or investor sentiment toward the company.
- So when a company buys back its shares, it reduces the number of outstanding shares in the market. The denominator goes down.
- Therefore, the share price must increase for market capitalization to stay constant.
What is the potential downside of share buyback?
Typically, buying back shares signals that the company is optimistic about the prospect of the business and thinks that the market is undervaluing the share price. But be wary: sometimes, management executes share buyback because their compensation is tied to share price performance or because a significant portion of their compensation is in the form of equity. This can create a distorted alignment of incentives where management initiates share buyback to hit their targets or inflate their compensation.
If a company conducts share buyback when its share price is overvalued, it is essentially paying more than it should for its own shares. This can reduce the company’s ability to invest in new projects, pay dividends, or weather future economic downturns. As a result, the share price eventually falls, and shareholders lose value in their investments.
What are the benefits of share buyback over dividends?
Compared to dividends, share buybacks are a more flexible way to redistribute cash to investors. As mentioned, dividends are sticky because canceling or reducing them can negatively impact the share price. In contrast, share buybacks can be deployed by management on an as-needed basis. Management can be more opportunistic when doing share buyback.
How are share buybacks taxed?
Investors are not taxed for share buyback because the benefits to investors are realized through share price appreciation rather than direct cash distribution. Investors would experience capital gain taxes only when they sell their shares.
Companies have already paid taxes for the profits they generated. In the past, they didn’t have to pay tax when they engaged in share buyback. But, with the introduction of the Inflation Reduction Act of 2022, starting January 2023, companies must pay a 1% excise tax. To put things into perspective, had the rule been in place earlier, Berkshire Hathaway’s $8 billion share buyback in 2022 would have incurred an additional $80 million in excise tax.
Re-investing in growing the business
The third way companies can reward investors is by continuing to invest in the business for the long term. This means the company uses its excess cash to invest in itself rather than payout via dividends or buybacks. This can involve spending on research and development, expanding into new markets, or acquiring other companies. All these activities, ideally, result in a higher enterprise value for the company. And over time, this will result in a higher share price, which will benefit the shareholder.
But as a shareholder, there are a few things you must consider with buybacks:
- Because investments in the business may take a long time before the desired outcome is evident, it may take a long time before investors reap the benefits of these investments.
- Management may not be savvy in investing or growing their own business. As such, cash invested in the business may yield lower returns than if returned to the investors. One way to calculate this is to measure a business’s return on invested capital (or ROIC). The ROIC should be sufficiently high for investors to assume the additional waiting period and risks.
With the two considerations above, one can see that getting returns based on management’s ability to re-invest and grow the business is the most indirect option and carries the highest risk (compared to dividend and share buyback). The outcome can vary largely with the nature of the business and management’s ability. But, at the same time, this method can generate the highest returns for investors.
One example is Amazon and Jeff Bezos’s preference to re-invest in the business, foregoing dividends and share buyback. With this approach, the company established significant adjacent businesses that have significantly increased the value of the company (and, therefore, the share price over time). For example:
- Amazon created the hugely popular Kindle and established a digital book store business, an adjacency from its roots as an internet retailer of physical books.
- In 2006, Amazon launched Amazon Web Services (AWS), the first cloud platform that serves other companies, becoming a pioneer in a multi-billion dollar market. Currently, at a 39.89% operating margin, AWS is the most profitable segment of the company’s business.
- Over the past decade, Amazon invested heavily in distribution and logistic services, enabling the company to deliver items within two days for Prime members. At present, the company ships more packages than FedEx.
- In recent years, the company has established itself as a platform for 3rd party sellers, allowing it to charge advertising on its web store. Currently, Amazon is the third largest digital ad player in the US.
The above is an example of a successful capital reinvestment strategy. However, for every Amazon, one can probably cite more failed capital reinvestment strategy examples. As an investor, it is wise to evaluate management’s track record in growing and investing wisely. One way to do this is to read the shareholder letter management publishes in its quarterly earnings release (hint: just search for the company and “IR,” short for Investor Relations).
How is re-investing in growing the business taxed?
For the investor, there are no direct tax implications. For the company, re-investing in the business is more tax efficient because any R&D can reduce the tax burden. In order to increase research and experimentation in the United States, Congress offers tax incentives for such expenses.