Stock buybacks, also known as share repurchases, have been in the news lately after a flurry of them happened this year. While many investors are familiar with how dividends work, the decades-long trend of firms returning cash to investors through buybacks in lieu of dividends may have some investors wondering how they differ. The process and ramifications, in fact, are quite similar.
In both cases, a firm spends a cash surplus from its earnings. In the case of a dividend, this cash is distributed directly to investors. This reduces the company’s market cap, as the price per share drops by the dividend per share amount. That cash distribution represents economic value being transmitted to the investors. It also reduces the company’s book value by the same dollar amount, because the dividend was sourced from an asset (cash) of the firm.
Buybacks can be executed by a firm repurchasing its own shares on the open market or making tender offers to buy shares at a certain price, up to a certain amount. Spending on buybacks reduces book equity by the same value as dividends. Market value also drops the same—although the price per share is not directly affected, the total number of shares is reduced. The resulting price-to-book ratio is the same as it would be in the dividend scenario.
A company may prefer buybacks based on tax considerations or if it believes the stock is undervalued by the market. Investors may also prefer one over the other. But the important takeaway is for investors to think of buyback programs similarly to dividend payments: a component that, along with capital appreciation, may contribute to an investor’s total return.
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