The Difference Between Share Buy-Backs and Dividends
I get a lot of questions from confused investors wondering what the differences are between share buy backs and dividends.
Simply put, the company uses existing cash for both purposes, the difference is that dividends go directly into your pocket, which you have to pay taxes on, while the share buyback goes to purchasing shares on the open market, which are then retired after purchase. This action reduces the number of shares outstanding, so profits are then divided amongst fewer shares.
Example, a company has 100 shares outstanding, and earns $100. That would be earnings of $1 per share. ($100 divided by 100 shares outstanding) Now, the company uses existing cash to purchase 20 shares, reducing the number of shares to 80, now the same earnings are divided by 80, so you get earnings per share of 100/80 so you get earnings of $1.25 share. Of course, with rising earnings per share, the stock price rises accordingly.
Also, with a share buy back, taxes are deferred until you sell the shares.
Video: Difference between share buybacks and divdends
So why in the world would anyone prefer a dividend, which is immediately taxable as a long term capital gain?
1) share buybacks are often undertaken at the wrong time, (when the price of the company is high) thus shareholders get poor value for the money expended
2) buybacks are often used by management to support the price of the stock by management while they unload their massive number of stock options purchased at much lower prices. Basically, they are using shareholder money to reward themselves.
3) dividends make management be more fiscally conservative, knowing they'll have to pay out shareholders x dollars per quarter.
4) many investors only invest in dividend paying stocks, which helps act as a support floor for the stock.
The truth is, unless its Warren Buffet who's managing the stock buyback (which he recently announced he would do at Berkshire Hathaway if the shares traded 10% below what he considered their intrinsic value, I would opt for the dividend.