Dividends And Buybacks: Practical Differences, By Michael MauboussinVW Staff
Michael Mauboussin piece…. Michael Mauboussin has authored books, Think Twice: Harnessing the Power of Counterintuition and More More Than You Know: Finding Financial Wisdom in Unconventional Places.
The purpose of a company is to maximize long-term value. As such, the prime responsibility of a management team is to invest financial, physical, and human capital at a rate in excess of the opportunity cost of capital. Operationally, this means identifying and executing strategies that deliver excess returns. Outstanding executives assess the attractiveness of various alternatives and deploy capital to where its value is highest. This not only captures investments including capital expenditures, working capital, and acquisitions, but also share buybacks. There are cases where buying back shares provides more value to continuing shareholders than investing in the business does. Astute capital allocators understand this.
Exhibit 1 shows how companies in the U.S. have apportioned dollars over the past quarter century in capital expenditures, M&A, share buybacks, and dividends. From 1985 through 2011, spending on capital expenditures was roughly twice that of M&A. Spending on M&A was about 50% higher than dividends and buybacks combined. So for every dollar spent in these four areas, roughly $0.55 went to capital spending, $0.27 to M&A, and $0.18 to dividends and buybacks.
Research shows that capital expenditures can generate returns in excess of the cost of capital, and it appears that they have done so in the aggregate over the past 25 years.1 M&A creates value if you consider the seller and buyer together, but the value tends to go to the seller while buyers earn about the cost of capital. 2 Buyers tend to do worse the larger the percentage premiums they pledge to acquire their targets, and research shows that the market’s initial reaction to M&A is not biased.
Not surprisingly, the exhibit reveals that the year-to-year changes in capital expenditures and dividends are much more modest than those for M&A and share repurchases. Indeed, M&A and buybacks follow the economic cycle: Activity increases when the stock market is up and decreases when the market is down. This is the exact opposite pattern you’d expect if management’s primary goal is to build value.
Executives should always seek to allocate capital to the opportunities with the highest returns. But M&A and share buybacks generally happen when times are good and don’t happen when times are more challenging, meaning that executives struggle to consistently create value with these investments. While there may be an economic rationale for a pattern that follows the economic cycle—access to capital may be more challenging in tougher times, for example—it’s more likely a case of mental accounting: capital expenditures and dividends have priority to M&A and buybacks irrespective of the prospective returns from the alternative investments.
In theory, dividends and buybacks are equivalent assuming no taxes, identical timing of cash receipts, and an efficient market. 4 In practice, they are very different. Take, for example, the issue of taxes. Even when the tax rates for dividends and capital gains are the same, as they are now, there’s an advantage to buybacks. This is because a shareholder can choose to defer tax payments by not selling shares today— think of this as refusing a “dividend” today in exchange for a potentially larger dividend down the road. Paying a tax bill in the future is better than having to pay one today.
See Full PDF here: Share Repurchase from All Angles