Why share buybacks are nothing like dividends

When big companies buy back their own shares, it's often pitched as a return of cash to shareholders', not unlike a dividend.

But don't let them pull the wool over your eyes. Buybacks are nothing like dividends, and in general, they're far better for managers and big institutions than they are for small shareholders.

Here's why share buybacks are popular

Let's says that Andy, chief executive of ice cream giant Andy's Ices, gets a phone call from his stockbroker.

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"Hey Andy," says the stockbroker, "your business is doing fine at the moment but we really need to get the share price moving up a bit.

"I've been thinking. If you use some of that cash you've been sitting on and buy back 10% of your shares, then there'll be fewer shares around. That'll boost earnings per share (EPS). The market will love it."

Andy thinks for a while. As the company's biggest shareholder, he likes the prospect of a higher share price but that's not the only attraction. As chief executive, Andy's bonus is also linked to growth in the company's EPS. So if he can push up EPS with a buyback, then he'll get a bigger bonus.

He agrees that it's a good idea and tells the broker to start buying shares. The delighted broker puts the phone down and heads off to the wine bar, dreaming of all the commissions his firm will get from the share buyback.

The City and the media greet the news of the buyback with great fanfare. But is it a good deal for investors? Or just for Andy and his broker?

EPS growth and shareholder value are not the same

Let's get one thing clear here. A buyback can be good news for shareholders. But and this is the key issue - this is only true if the company buys the shares for less than they are worth. In other words, companies need to consider value for money, just as with any investment, even when buying their own shares.

Here's an example of why this matters. Let's take a look at Andy's Ices.

Andy's Ices is a good business. It makes £1bn in annual operating profit and currently has £1bn in cash on its balance sheet. It has no debt.

Based on how much future cash can be taken out of this business, the fair value (or intrinsic value) of its operations is £10bn (I've used a discounted cash flow valuation here).

Adding £1bn of cash gives us an equity value of £11bn or £11 per share. This equates to a p/e ratio of 15.4 times. (Note, the value of the business determines thep/e ratio, not the other way round.)

Now look at what happens when the company uses its £1bn of cash to buy back its own shares.

You can see from the table that the price paid is all-important. All three scenarios enhance EPS. But only one buying shares for less than their fair value - makes shareholders richer.

More to the point, while buying cheap shares makes sense, shareholders can choose whether or not to do this themselves by reinvesting their dividends. They don't need the company to make the choice for them.

But what about tax?

Buybacks are seen as a tax efficient way of giving cash to shareholders. The cash is not subject to income tax as is the case with dividends. But this argument is really only relevant to higher-rate taxpayers. It is not an issue for shares held in pension plans or Individual Savings Accounts (Isas).

Some corporate financiers argue that buying back shares with increased borrowings is a good strategy. Interest payments on debt are a tax-deductible expense. Having more debt can therefore lower a company's tax bill and increase its value.

However, we'd disagree on this score too. As debt holders get paid before shareholders, increasing the amount of debt held makes the equity more risky. This offsets any value from saving tax.

The fact is (as the example above shows) that the value of a business's operations does not change when its financing changes. But the value of equity can, and not always in a positive way.

Forget buybacks - special dividends are much better

Dividends are tangible cash returns to shareholders. Once paid, they cannot be taken away. Share buybacks are not. Indeed, if managers use share buybacks to boost EPS and so earn bonuses they'd have otherwise missed, they are effectively using shareholders' money to enrich themselves.

In short, if a company is sitting on too much money and it can't think of anything better to do with it, we'd much rather see it paid out in special dividends, than used to ramp up EPS.