Question

What are the advantages and disadvantages of stock repurchases relative to traditional dividend payments?

Answer 1

Advantages and Disadvantages of Dividends and Stock repurchases

Of course, in the real world, things seldom work out so conveniently. Here are some additional considerations with regard to stock repurchases versus dividends:

Returns Aren't Guaranteed

The future return with a share stock repurchase is anything but assured. For instance, let's say that FLUF's business prospects tanked after Year 1, and its revenues fell 5% in year two. Unless investors are willing to give FLUF the benefit of the doubt and treat its revenue decline as a temporary event, it is quite likely that the stock would trade at a lower price-per-earnings multiple than the 10 times earnings at which it generally trades. If the multiple compresses to 8, based on an earnings-per-share of $2.22 in year two, the shares would be trading at $17.76, a decline of 11% from $20 per share.

A Boost for Low-Growth Companies

The flip side of this scenario is one enjoyed by many blue chips, in which regular stock repurchases steadily reduce the number of outstanding shares. The reduction can significantly boost earnings-per-share growth rates even for companies with mediocre top-line and bottom-line growth, which may result in them being accorded higher valuations by investors, driving up the share price.

Wealth Building

Share stock repurchases may be better for building wealth over time for investors because of the beneficial impact on earnings-per-share from a reduced share count, as well as the ability to defer tax until the shares are sold. Stock repurchases enable gains to compound tax-free until they are crystallized, as opposed to dividend payments that are taxed annually.

In the case of non-taxable accounts where taxation is not an issue, there may be little to choose between stocks that pay growing dividends over time and those that regularly buy back their shares.

Disclosure

A major advantage of dividend payments is that they are highly visible. Information on dividend payments is easily available through financial websites and corporate investor relations sites. Information on stock repurchases, however, is not as easy to find and generally requires poring through corporate news releases.

Flexibility        

Stock repurchases provide greater flexibility for the company and its investors. A company is under no obligation to complete a stated repurchase program in the specified timeframe, so if the going gets rough, it can slow down the pace of stock repurchases to conserve cash. With a stock repurchase, investors can choose the timing of their share sale and consequent tax payment. This flexibility is not available in the case of dividends, as an investor has to pay taxes on them when filing tax returns for that year. Although dividend payments are discretionary for a dividend-paying company, reducing or eliminating dividends is not viewed favorably by investors. The result could lead to shareholders selling their shareholdings en masse if the dividend is reduced, suspended or eliminated.