Readers here at Investment Moats would consist of mainly the value investors and the dividend investors. For the dividend investors, what matters to them would be consistent and attractive dividend payouts at the right price.
Over here i do placed alot of emphasis on Free Cash Flow yield as compared to actual dividend payout (“Understanding Free Cash Flow” has a good writeup on this).
At the end of the day what matters to value investors or dividend investors are not payments but that the company is generating consistent cash flow.
What is generally omitted for discussion is Stock Buy Backs
Increasing Earnings Per Share
Recalling the article in “Understanding Free Cash Flow”, the firm’s cash can be allocated to
- pay off debts
- pay out as dividends
- purchase capex or subsidiaries
- keep as cash
- buy back stocks
Stock buy backs normally occurs when the company feels that their share is undervalue or that there is no good investments out there for them to generate a higher return. As a result the sensible thing to do is to buy back their own share.
The effect of this is that the number of outstanding shares of the firm is reduced and when net profit is divided by less outstanding shares it inevitably increase. When EPS increases it theoretically translates to a stronger share price since share price is a function of earnings.
Tax advantage of stock buy backs
Perhaps not in a local context, firms that choose to do buy backs more than pay out dividends thinks for the customers when capital gains tax is lower than dividend taxes. This does not matter in countries like Singapore and Hong Kong where the stocks are not subjected to capital gains taxes
Advantage to managers with stock options
Most decision makers in the company have stock options and paying out dividends subject the company to the occasion dip in share price during ex-dividends. Stock buy backs make better sense to them as stock will typically appreciate wwhich creates more value for them
Advantage if firm allocates well and Disadvantage if they do not
Typically it is a double edge sword. You would notice alot that Singapore companies buy back shares at almost anytime. its as if they really cannot find a better way to generate additional shareholder value.
If there are better investment out there a good manager would buy over that investment instead of investing in itself.
Take the case of YangZiJiang. Its a good stock with a great balance sheet but alot of its cash holdings are invested in China bonds yielding 10%. That creates alot of cashflow for the firm not to mention shareholders.
A case of bad buy back is that if you know that your share price is overvalued, yet you still initiate a stock buy back.
Flexibility in expectation management
Companies sometimes are held ransom to declaring these fixed dividend policy. Essentially the difference between equity and bonds is that dividends are not mandatory. Yet if you tell me that Starhub or Singtel is going to cut dividends there will be a huge outcry. They have become somewhat of a quasi-bond.
Buy back enables a company not to be held at ransom to these past decision. Add value only when it is possible to.
Professor Damodaran’s Stock Buyback Series
I am not the best educator in this area but i found Professor Damodaran’s take on the shift in US dividend policy to be enlightening.
- Stock Buy Backs:What is it and Why
- Buy backs and stock prices: An Example
- The shift to stock buy backs: Implications
- Dividend policy for the 21st Century
I believe buy backs are good. But of more importance is that buy backs gives you an insight to how well the management team manages this.
It is a barometer to whether this management has what it takes to help you allocate money. Should you see that they are not doing a great job, it is perhaps prudent for all shareholders to call for more dividend payment instead of letting the management mis-manage.
That said this is somewhat like a comparison of Starhub and Singtel. According to my Dividend stock tracker, Singtel pays out less per EPS compared to Starhub. If Singtel have a high ROE it make sense for them to help us allocate capital. The problem is that Singtel has been paying out less yet their ROE lags for these new investment. So the question is: If you are a Singtel share holder which would you prefer?
I run a free Singapore Dividend Stock Tracker available for everyone’s perusal. It contains Singapore’s top dividend stocks both blue chip and high yield stock that are great for high yield investing. Do follow myDividend Stock Tracker which is updated nightly here.