What is Share Buyback?
It is the company buying back shares of itself to reduce the number of shares outstanding, and in return increase the value each share is worth.
For a more in-depth explanation about it, refer to the Investopedia page HERE.
Why Companies (particularly US companies) Love Share Buyback?
The main reason: Tax
In the US and other countries, shareholders have to pay a dividend tax for the dividends they receive.
In the US, the nominal tax rate is 30%.
This causes shareholders to experience double taxation - once on the company's profits, then again on the dividends paid out of the profits.
To avoid double taxation, companies use share buybacks as a way of "giving" returns back to shareholders.
The math of Share Buybacks
You can skip this if you know how buyback works
A company made $1 million in profits, has 1 million shares outstanding, and a PE of 10.
The current share price of the company is $10, and the Earnings Per Share (EPS) is $1.
If the company bought back 10% of its shares (100,000 shares), the EPS will increase from $1 to $1.11 ($1m profits / 900k shares).
Assuming the PE of 10 does not change, the new share price will become $11.11 (an 11% increase just by reducing the share count by 10%).
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The Math Portion of Why Buyback Is Better Than Dividend
A company made $1 million in profits, has 1 million shares outstanding, and a PE of 10.
The current share price of the company is $10.
Assuming the company grew earnings by 4% this year, the new share price will become $10.40.
Assuming that the company pays a 2% dividend, which means it will pay out $200,000 in dividends.
As a shareholder, you will earn 6% this year.
Now, instead of spending $200,000 in dividends, it used the $200,000 to reduce the shares outstanding via a share buyback.
At $10 per share, $200,000 will buy back 20,000 shares or 2% of the shares outstanding.
With a 4% growth rate, profit becomes $1.04 million, divide by 980,000 shares, the EPS becomes $1.06.
The new share price will become $10.60, you as the shareholder will still earn that 6% return.
Problem with Share Buybacks in Singapore
1. Dependence on the Company Performance
When you get a dividend, it is cash into your pocket you can use to invest in other companies or buy things you like.
When you get buyback, you get no cash, but your ownership in the company increases.
If the company grows and earns more, your increased ownership in the company will be worth more.
But if the company shrinks, your ownership in the company will be worth less - worse still, you have no dividends to help you cushion the blow or to use as funds to buy more of the company's shares at a lower price.
2. No Tax Efficiency
In the US (and other countries), dividends are taxed, but share buybacks are not.
Hence from the shareholders' perspective, it might be better to spend cash doing share buybacks than paying out as dividends to avoid taxation.
But in Singapore, dividends are tax-free.
So the idea that "buybacks are better than dividends because of tax advantages" no longer works in Singapore's context.
3. Management Problems
I often tell my friends the statement below when explaining why I prefer Singapore companies do dividend over buybacks.
"I much rather they give me the cash and let me decide what to do with the money than let management hoard the cash. Rather I make a mistake with my money and lose it than for management to make a mistake with my money and lose it."
Of course, there are good companies that really make great use of shareholders' money to reap even higher returns, like what Warren Buffett did for Berkshire Hathaway.
But then again, how many Warren Buffett and Berkshire Hathaway do you really see in the world?
The probability of investing into the next Warren Buffett or Berkshire Hathaway is fairly low actually.
4. Company Problems
IBM spent US$83 billion on share buybacks over the past decade, but the stock price and market capitalisation went nowhere.
As an investor of IBM, it might be better had they just gave all that US$83 billion out as dividends.
Even though shareholders have to pay taxes, but at least they will still have US$58 billion and a shrinking company, instead of now where they have no cash but huge ownership in a shrinking company.
Source: IBM Market Cap
Source: IBM Stock Price
Conclusion
Share buybacks can be great for shareholders if they are done correctly.
Except it is really difficult for it to be done correctly.
Warren Buffett (world's greatest investor) set a limit on his buyback activity - he would only buy back shares if the share price fell to below 1.2x his company's book value.
At 1.2x, he considers his company to be undervalued enough to justify buying back shares and benefiting those shareholders who held on to their shares.
Unfortunately, most management teams do not have such discipline - particularly so since almost no management will ever say their share price is undervalued, even if it is significantly overvalued.
Hence, it might be better, if we as shareholders demand higher dividend payouts and fewer share buybacks!
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They can link you up with the career coach and you might be able to find new opportunities on their jobs portal.
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