Why do companies disregard taxes and their negative effect on compounding value?

[JSArbitrage]

also optimizing for Cash Flow vs P&L is a complicated topic and not every business is in a situation where they can do that.  In a rational world the accrual accounting and the cash flow accounting eventually matchup so that the only benefit is the time value of money.

 

that and there are in the long-term issues with optimizing for tax - especially for industries that sell to the public sector.

 

I completely agree and I will go further - most companies actually do their best at optimizing for tax; it's just there aren't nearly as many easy ways to do it as people think.  Secondly, the people that tend to do it aggressively don't just get fired, they end up in prison.

 

Trust me, as a Big 4 employee that works with our tax group fairly often on different matters, if there was a lever that could be pulled that would simply allow a company to legally shelter profits from taxes without other negative consequences, they'd pull that lever in a heartbeat. 

[morningstar]

I think buybacks are one of those concepts that work well in theory but tend to be far more destructive in practice. The reality is that most companies at any given time are not undervalued and that most people (including investors and company management) can't tell an undervalued company from an overvalued one with any reliability. For instance, one sees a lot of people demanding buybacks from Bank of America, a company that historically has destroyed tens of billions in capital through share repurchases - very few of which were opposed by investors to any meaningful extent.

 

Meanwhile, it's unavoidable that buybacks will be pro-cyclical, especially for banks whose capital return will be curtailed in times of market weakness.

 

 

[ERICOPOLY]

I think buybacks are one of those concepts that work well in theory but tend to be far more destructive in practice. The reality is that most companies at any given time are not undervalued and that most people (including investors and company management) can't tell an undervalued company from an overvalued one with any reliability. For instance, one sees a lot of people demanding buybacks from Bank of America, a company that historically has destroyed tens of billions in capital through share repurchases - very few of which were opposed by investors to any meaningful extent.

 

Meanwhile, it's unavoidable that buybacks will be pro-cyclical, especially for banks whose capital return will be curtailed in times of market weakness.

 

In all cases... Buybacks return capital to shareholders.  No exceptions.

 

Returned, not destroyed.

[topofeaturellc]

In a sense that's clearly true, but its also true that a poorly priced buy back or even worse, levered recap, can destroy a lot of the equity capital that was left behind.

[bookie71]

Buy backs only help the shareholder IF they buy stock back at LESS than intrinsic value.  Otherwise they help the exiting shareholder.

 

[ERICOPOLY]

No, and no.

 

1)  Buyback increases your ownership % stake

2)  You then sell an offsetting amount.

 

Voila!

 

3) No capital is destroyed.  You have the cash and the same % ownership stake as before.

 

You avoid being taxed on your cost basis.  Compare that to a dividend where you are taxed on the entire distribution.

[ERICOPOLY]

The share price (of the buyback) has absolutely nothing at all to do with it.

 

The person who destroys value by holding overpriced shares is... YOU!!!!!!  Don't blame the management, take responsibility for your own boneheaded decisions.  They buy some shares that you decide not to sell... you blame them.  Hmm... why is it again that you are still holding the shares anyhow?

[Myth465]

I always like watching you argue this point.

[Rabbitisrich]

The debate may be clearer if you focus on an outcome, and then work backwards to see the difference between dividends and buybacks. That also helps to keep the conversation apples to apples, and it should show that the question is NOT about buying back cheap stock versus issuing a dividend. That is an apples to oranges question because it assumes that you don't apply your dividend to purchasing the cheap stock. The appropriate question is whether it makes sense to return capital.

[Uccmal]

You folks realize that if buybacks were used instead of dividends exclusively, or even more closely to the level of dividends, that our governments would have to work out a way to tax them. 

 

So find companies that do buybacks well, and forget about the rest. 

 

And Eric, there is that point at which dividends make more sense for the shareholder than buybacks.  The point where the taxes on your dividends  are less than the spread between book value and buyback price.  Of course it is a number with alot of inputs so without using advanced Greek Formulae you can only estimate it.  This is why I think Buffett has roughly chosen 20% premium to book as his target.  30 -40% above book is likely closer to reality, but Buffett lands on the side of conservative, and profitable for Berkshire, nearly every time. 

[Uccmal]

The debate may be clearer if you focus on an outcome, and then work backwards to see the difference between dividends and buybacks. That also helps to keep the conversation apples to apples, and it should show that the question is NOT about buying back cheap stock versus issuing a dividend. That is an apples to oranges question because it assumes that you don't apply your dividend to purchasing the cheap stock. The appropriate question is whether it makes sense to return capital.

 

Kind of what I said.  We posted at the same time.  There is a large number of moving parts involved in the math here. 

[Rabbitisrich]

 

Kind of what I said.  We posted at the same time.  There is a large number of moving parts involved in the math here.

 

I disagree about the point at which dividends are more valuable than buybacks. The apples to apples comparison would be to fix your desired % ownership and arrive at the same cash balance via dividends or selling the excess % ownership (in the case of buybacks). Aside from technical issues, the first-order difference is in the tax treatment.

 

In order for dividends to beat buybacks in an apples to apples comparison, dividends would have to show a persistently higher valuation for the company.

[topofeaturellc]

The share price (of the buyback) has absolutely nothing at all to do with it.

 

The person who destroys value by holding overpriced shares is... YOU!!!!!!  Don't blame the management, take responsibility for your own boneheaded decisions.  They buy some shares that you decide not to sell... you blame them.  Hmm... why is it again that you are still holding the shares anyhow?

 

you are misinterpreting the question.  We're talking about managements decision making, not your decision making as a share holder.

 

Yes obviously you shouldn't own overpriced shares, but OP's point was that paying out is always the wrong decision - and it just isn't.  Its corp finance 101 not investing 101

[topofeaturellc]

 

 

In order for dividends to beat buybacks in an apples to apples comparison, dividends would have to show a persistently higher valuation for the company.

 

I don't have the data at hand but certainly there are periods of time (like today) when the market overvalues paying out as opposed to retaining capital for reinvestment.  I suspect the opposite was true during the Tech bubble - dividends were undervalued and retained earnings assumed to be reinvested at an unreasonable rate of return.

[ERICOPOLY]

The share price (of the buyback) has absolutely nothing at all to do with it.

 

The person who destroys value by holding overpriced shares is... YOU!!!!!!  Don't blame the management, take responsibility for your own boneheaded decisions.  They buy some shares that you decide not to sell... you blame them.  Hmm... why is it again that you are still holding the shares anyhow?

 

you are misinterpreting the question.  We're talking about managements decision making, not your decision making as a share holder.

 

Yes obviously you shouldn't own overpriced shares, but OP's point was that paying out is always the wrong decision - and it just isn't.  Its corp finance 101 not investing 101

 

I believe your comment is directed at the gentleman who opined on Bank of America's buybacks destroying shareholder value.  Of course, in that case it was the shareholder's decision to hold that did the self-inflicted damage.

 

He might have changed the topic of the conversation, and then I replied.  However, it's how things go on these boards.

[Uccmal]

 

Kind of what I said.  We posted at the same time.  There is a large number of moving parts involved in the math here.

 

I disagree about the point at which dividends are more valuable than buybacks. The apples to apples comparison would be to fix your desired % ownership and arrive at the same cash balance via dividends or selling the excess % ownership (in the case of buybacks). Aside from technical issues, the first-order difference is in the tax treatment.

 

In order for dividends to beat buybacks in an apples to apples comparison, dividends would have to show a persistently higher valuation for the company.

 

There are more moving parts than you mention.  You cant get to an exact number.  Roughly speaking you are correct.  I have tried working up examples but it is not as simple as it seems.  Once you add in market fluctuations in stock prices, growth rates etc., you can only get to a range where buybacks are preferred over dividends.  My best guess is it is around the tax rate for dividends which of course varies per individual. 

 

 

[ni-co]

The apples to apples comparison would be to fix your desired % ownership and arrive at the same cash balance via dividends or selling the excess % ownership (in the case of buybacks). Aside from technical issues, the first-order difference is in the tax treatment.

 

Exactly. However, you have to factor in capital gains tax for the ownership adjustment after the buyback. If you assume the same tax rate on capital gains and dividends and if you don't want to reinvest the cash, there wouldn't be a difference.

 

Reinvestment is my point, though (and therefore the valuation of the company matters for the buyback). I don't want the company to decide for me when to cash in parts of my ownership. If I wish to have cash, I will sell part of my shares. The standard assumption that for some reason most shareholders want to receive 2% or so of their holdings' worth in cash every year and don't mind paying tax on it just doesn't make any sense.

 

In order for dividends to beat buybacks in an apples to apples comparison, dividends would have to show a persistently higher valuation for the company.

 

Not even then, because I'd also have to buy at a higher valuation then.

[ERICOPOLY]

If you assume the same tax rate on capital gains and dividends and if you don't want to reinvest the cash, there wouldn't be a difference.

 

There would certainly be a difference unless your costs basis is zero.

 

Example... I buy BAC at $15 -- that's my cost basis.

 

dividend:

they pay a $1 dividend.  I pay 33% tax on that dividend.  I'm left with 67 cents on the dollar.

 

repurchase:

Management decides to repurchase $1 of stock for $15 per share.  I sell an offsetting amount of shares at $15 price point (same as my cost basis).  I'm left with $1 in cash.  No taxes whatsoever!

 

I have roughly 50% more cash if management buys back stock instead of paying a dividend.

 

[ni-co]

If you assume the same tax rate on capital gains and dividends and if you don't want to reinvest the cash, there wouldn't be a difference.

 

Yes, there would certainly be a difference unless your costs basis is zero.

 

Example... I buy BAC at $15 -- that's my cost basis.

 

dividend:

they pay a $1 dividend.  I pay 33% tax on that dividend.  I'm left with 67 cents on the dollar.

 

repurchase:

Management decides to repurchase $1 of stock for $15.  I sell an offsetting amount of shares at $15 price point (same as my cost basis).  I'm left with $1 in cash.  No taxes whatsoever!

 

I have roughly 50% more cash.

 

With the difference that in case 1 you're left with a stock price of $14 and in this way get $1 of tax free price appreciation (potentially).

[ERICOPOLY]

If you assume the same tax rate on capital gains and dividends and if you don't want to reinvest the cash, there wouldn't be a difference.

 

Yes, there would certainly be a difference unless your costs basis is zero.

 

Example... I buy BAC at $15 -- that's my cost basis.

 

dividend:

they pay a $1 dividend.  I pay 33% tax on that dividend.  I'm left with 67 cents on the dollar.

 

repurchase:

Management decides to repurchase $1 of stock for $15.  I sell an offsetting amount of shares at $15 price point (same as my cost basis).  I'm left with $1 in cash.  No taxes whatsoever!

 

I have roughly 50% more cash.

 

With the difference that in case 1 you're left with a stock price of $14.

 

Okay, now (to fix both cases in my example) you could also comment on case 2 where you would also arrive at a total value of $15.

 

You fixed the first case but not the second.  Were you to fix both, you'd have $15 left in both scenarios, but after paying taxes in case 1 you'd only have $14.67.

 

So it's $14.67 vs $15?  I'll take $15 every time.  Meaning... every time.  Don't care where the stock is trading, I just want more money every time.

 

[yadayada]

why are we having this discussion? if stock is fairly valued, buyback is better because lower taxes for cap gains right?

 

But because we are value investors, buybacks are always better.

 

If you say buybacks are not better, you are basicly saying that your a  bad value investor. Because your holding a bunch of overvalued stocks.

 

So can we end this discussion right now please :D

 

If you disagree, I invite you to work out some examples and see what will yield a higher pay out over time.

 

It would be a lot more interesting if we would discuss examples of reinvesting in business vs buying back on a cheap stock.

[writser]

As long as you assume the market is completely rational. If, for any reason, other market participants prefer dividends over buybacks and the stock price moves up sharply when a company announces a generous dividend policy then I'll happily join the dividend camp (assuming I have a position already).

[ERICOPOLY]

If you assume the same tax rate on capital gains and dividends and if you don't want to reinvest the cash, there wouldn't be a difference.

 

Yes, there would certainly be a difference unless your costs basis is zero.

 

Example... I buy BAC at $15 -- that's my cost basis.

 

dividend:

they pay a $1 dividend.  I pay 33% tax on that dividend.  I'm left with 67 cents on the dollar.

 

repurchase:

Management decides to repurchase $1 of stock for $15.  I sell an offsetting amount of shares at $15 price point (same as my cost basis).  I'm left with $1 in cash.  No taxes whatsoever!

 

I have roughly 50% more cash.

 

With the difference that in case 1 you're left with a stock price of $14 and in this way get $1 of tax free price appreciation (potentially).

 

I understand your point now with the edit.  You're saying that potentially one day the capital gains taxes will be less.  That's true mostly... however deferred-taxation leads to better compounding results over time.  Also, here in the US you get a free step-up in cost basis when you die (or your wife if you live in community property state), so there won't be any capital gains taxes due at all in that case.

 

There will also be times when you sell the BAC shares below your cost basis... say management buys them back at $10 and you sell at $10.  So you'd have a $5 per share capital loss to deduct against the dividends that you are getting elsewhere in the portfolio.  So that really makes the math sweet -- instead of paying 33% on the dividend, you'll have a lower tax bill on the other dividends that you are collecting.  So the difference in cash could be well over 50%.

 

 

[morningstar]

If you assume the same tax rate on capital gains and dividends and if you don't want to reinvest the cash, there wouldn't be a difference.

 

Yes, there would certainly be a difference unless your costs basis is zero.

 

Example... I buy BAC at $15 -- that's my cost basis.

 

dividend:

they pay a $1 dividend.  I pay 33% tax on that dividend.  I'm left with 67 cents on the dollar.

 

repurchase:

Management decides to repurchase $1 of stock for $15.  I sell an offsetting amount of shares at $15 price point (same as my cost basis).  I'm left with $1 in cash.  No taxes whatsoever!

 

I have roughly 50% more cash.

 

With the difference that in case 1 you're left with a stock price of $14.

 

Okay, now (to fix both cases in my example) you could also comment on case 2 where you would also arrive at a total value of $15.

 

You fixed the first case but not the second.  Were you to fix both, you'd have $15 left in both scenarios, but after paying taxes in case 1 you'd only have $14.67.

 

So it's $14.67 vs $15?  I'll take $15 every time.  Meaning... every time.  Don't care where the stock is trading, I just want more money every time.

 

You are assuming a sale of stock by an investor, which is irrelevant to management's decision making. From management's perspective, share transactions only matter when they are with the company - when shares are issued, and when shares are bought back and cancelled. Otherwise, there is a shareholder and it's the company's job to maximize value for him. So here's BAC's perspective. Say they' start with 10 billion shares out - you have two options.

 

(1) Buy back 1 billion shares. My duty in this scenario is to my continuing 9 billion shareholders and I'm giving them each an extra stake in the company - a REINVESTMENT of continuing shareholder capital.

 

(2) Dividend equivalent cash. I still have 10 billion continuing shareholders and I've RETURNED their capital that I couldn't use.

 

Either my continuing shareholder has their stake + cash, or an increased stake. Clearly, if BAC is overvalued, my continuing shareholder should prefer the return of cash. The key is, from BAC's perspective its shareholders CANNOT SELL stock except to the company - they can change identity, but they continue to exist.

 

In short, the only way continuing shareholders can get cash out of a company is through dividends.

[ERICOPOLY]

If you assume the same tax rate on capital gains and dividends and if you don't want to reinvest the cash, there wouldn't be a difference.

 

Yes, there would certainly be a difference unless your costs basis is zero.

 

Example... I buy BAC at $15 -- that's my cost basis.

 

dividend:

they pay a $1 dividend.  I pay 33% tax on that dividend.  I'm left with 67 cents on the dollar.

 

repurchase:

Management decides to repurchase $1 of stock for $15.  I sell an offsetting amount of shares at $15 price point (same as my cost basis).  I'm left with $1 in cash.  No taxes whatsoever!

 

I have roughly 50% more cash.

 

With the difference that in case 1 you're left with a stock price of $14.

 

Okay, now (to fix both cases in my example) you could also comment on case 2 where you would also arrive at a total value of $15.

 

You fixed the first case but not the second.  Were you to fix both, you'd have $15 left in both scenarios, but after paying taxes in case 1 you'd only have $14.67.

 

So it's $14.67 vs $15?  I'll take $15 every time.  Meaning... every time.  Don't care where the stock is trading, I just want more money every time.

 

You are assuming a sale of stock by an investor, which is irrelevant to management's decision making. From management's perspective, share transactions only matter when they are with the company - when shares are issued, and when shares are bought back and cancelled. Otherwise, there is a shareholder and it's the company's job to maximize value for him. So here's BAC's perspective. Say they' start with 10 billion shares out - you have two options.

 

(1) Buy back 1 billion shares. My duty in this scenario is to my continuing 9 billion shareholders and I'm giving them each an extra stake in the company - a REINVESTMENT of continuing shareholder capital.

 

(2) Dividend equivalent cash. I still have 10 billion continuing shareholders and I've RETURNED their capital that I couldn't use.

 

Either my continuing shareholder has their stake + cash, or an increased stake. Clearly, if BAC is overvalued, my continuing shareholder should prefer the return of cash. The key is, from BAC's perspective its shareholders CANNOT SELL stock except to the company - they can change identity, but they continue to exist.

 

In short, the only way continuing shareholders can get cash out of a company is through dividends.

 

A person who sells an offsetting amount of shares is a "continuing stakeholder".  You claim management's duty is to continuing stakeholders.

 

It's the ownership % that matters.  A person who sells some offsetting amount of stock is not an "exiting shareholder".  He is merely keeping his ownership unchanged and would like management to serve his best long term interests -- distributing capital in the most tax-efficient manner is doing exactly that.