The Best Way To Pay Cash To Investors: Dividends Versus Buybacks Versus Reinvestment

Profits are the reward for any successful business and they are what investors seek at the end of the day, but management must be diligent in how the cash from these profits is returned to investors. Once a company has earned a significant return on the bottom line, there are three approaches that can be taken to repay investors, each coming with unique benefits and consequences. Dividends are the most common tool and they have been an investor favourite for quite a while, which may be the reason why the majority of equities now have a dividend even though they may not be a typical ‘income security’. Share repurchases are a less-known tool that management can use when they believe the intrinsic value of the stock is much greater than the current market price. This essentially means that management believes the company’s equity is undervalued for any number of reasons. Finally, the third choice would be to reinvest the profits into further projects that can help generate a greater return, or simply hold onto to the cash to create increased balance sheet liquidity. Firms that still have growth prospects within their industry or have a significant advantage over competitors commonly use this last choice. The three styles of repayment also align with what most investors view as the main investing styles. Income investors focus on the dividend yield and payment growth as the primary method for return; value investors focus on stocks that are undervalued by the market with a high margin of safety and long-term investment style as the primary method for return; and growth investors focus on the realization of new high-return projects to drive revenues and hopefully profits. Once you determine your personal financial goals and investment style, these three methods can help ensure that the companies you invest in are appropriate for your portfolio.

Dividends:

As stated before, income investors are the individuals who mainly focus on the level of dividend payouts and the growth of these dividends over time. A model that can be used for determining the value of a stock based on the future dividend payments is the Dividend Discount Model (Gordon Growth Model), a model that has been used for many years as a base model for valuation. Industries that are commonly considered to be high dividend payers include utilities, energy, telecommunications, real estate investment trusts and many financial institutions that use high amounts of leverage.

When determining whether income investing is right for you or not, the main factors to consider are the tax implications you have from receiving additional income and the required level of liquidity you need. Individuals preparing for retirement or those who have income requirements are typically better suited to this style, as it should offer lower volatility while providing short-term returns that do not require liquidation from the position in the form of dividends. Even with the dividend tax credits and other credits that can be used against this type of income, capital gains still are taxed at a lower rate, with only 50% of the net proceeds from the sale of securities being counted as ‘income’. Another downside to this style of investment is that in the case of a Canadian investor holding international equities, the dividends received from the international portion of the investor’s portfolio will be accounted as non-registered dividend payers and as such, the dividend credit will not be issued for that amount.

Share Buybacks:

When the market decides to undercut the value of a stock, there is very little the executives of a company can do to fight this valuation, except buying back stock. This method reduces the number of publicly traded shares by purchasing them back with cash or debt; once those shares are retired, the earnings for each share in the market become greater. This method helps reduce stock dilution over time and allows management to set supports for the company stock price. If the market sets an unreasonable price (in management’s eyes), the management has the ability to take advantage of this distortion and create additional value for the shareholders. Additionally, this  way to repay investors is much more tax-efficient as it provides the same value, but the value is given to investors through a capital gain rather than an income stream. If the market reacts appropriately and the shareholder is willing to wait a longer period for realization of the return, this style of repayment can be much more beneficial to the investors.

To determine if a stock is a value stock, it is common to look at the EV/EBITDA (Enterprise Value/Earnings Before Interest Taxes Depreciation and Amortization) ratio and compare it to the P/E ratio. If the P/E of the equity becomes lower with more debt being added to the capital structure, the equity is commonly determined to be a value stock.

Many of the greatest investors have been considered to be value investors, including Warren Buffet, Benjamin Graham and Seth Klarman. This style yields low volatility for the investor while presenting a high potential upside in the case that the market is proven wrong on its negative outlook. The risk in this style of investing lies in determining whether the issues that are causing the discount of a stock are material and whether they will last beyond the short term. Management that begins to repurchase stock may sometimes do so out of making appearances or because they simply have extra cash to return that would not be sustainable as a dividend, rather than believing the market value is under the true value of stock. This is why share repurchases are one of the best tools, in my opinion, for providing returns to investors but at the same time are one of the most complex.

Reinvestment:

All companies require certain amounts of capital expenditure every year, regardless of what industry or type of position a company is in. To identify whether a company is utilizing extra cash as a driver for growth is difficult. When a company has gained a large amount of capital, potentially through debt and equity financing, and is taking on risky ventures that can either improve margins or help increase market share, they are often considered to be in a growth position. A way to determine if a stock is being valued as a growth company by the market is to look at the EV/EBITDA ratio and compare it to the P/E ratio. If the P/E of the equity becomes greater with more debt being added to the capital structure, the equity is commonly determined to be a growth stock.

The risk of these companies are much greater when compared to value and income stocks, as the projects being undertaken usually require large amounts of capital being used for new and unprecedented projects. With debt leveraging the potential return, a single failure within management or the project can jeopardize the entire prospects of the additional growth and can send a stock the opposite way just as fast as it was going up. A retiree looking to gain a nominal return every year to guarantee sufficient income until the end of retirement should not normally look towards growth as these investments carry much more volatility. However a young adult who has just begun investing may have a greater appetite for risk and may be willing to undertake these types of risk/reward scenarios, which could make growth stocks a perfect fit for them.

Shawnvir Cheema is an Investment Analyst intern for 5i Research Inc., and an undergraduate student at Wilfrid Laurier University’s School of Business & Economics.

chee7530@mylaurier.ca