Justification for Buyback vs. Dividend
Companies are in business to earn a profit and stockholders buy shares of stock to participate in company profits. Some companies choose to distribute earnings directly to investors in the form of cash dividend payments. Some companies choose instead to buy back shares of their own stock, indirectly distributing earnings to investors. Buying back stock can offer investors certain advantages over paying them dividends.
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Increased Equity Per Share
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When a company buys back its own stock, it reduces the number of stock shares that are owned by investors. This reduction in shares outstanding increases the ownership percentage each remaining share represents. Contrast this to companies that distribute earnings using cash dividends. If a company pays a dividend, the dividend is shared by all shareholders. The more shares of stock that exist, the more earnings are diluted per share of stock.
Share Price Growth
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On the day a company pays a dividend, the exchange the stock trades on reduces the share price of the stock by the amount of the dividend before the market opens. In other words, investors receive cash in hand, but the price of their shares are reduced to account for the distribution. When a company announces a share buyback plan, however, stock prices typically rise immediately in response to the announcement. In addition, because buybacks increase the ownership percentage represented by each share of stock, share prices can potentially grow more rapidly in the future than similar companies that distribute earnings using dividends.
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Tax Deferral
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Dividends and capital gains are taxed separately. If you own stock that pays dividends, you are taxed on your dividends during the year they are paid, but you do not have to pay capital gains tax on the growth of your stock until you actually sell the stock; even if you hold it for years. When you own stock in a company that buys back shares instead of distributing earnings through dividends, the taxes on your investment are fully deferred until you sell your stock.
Buybacks Reveal Company Confidence
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When a company buys back its own stock, it sends the message to investors that company shares are valuable. Companies typically have a good understanding about their own value. Many companies buy back their own shares when company executives determine that the shares are undervalued.
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