In some ways, stock buybacks benefits are better than dividends. In particular, they give you a tax-deferral option that you don’t get with cash dividends.

It’s odd that while Successful Investors generally crave cash dividends, they rarely get excited about stock buybacks. But in some ways, stock buybacks are better than dividends. In particular, they give you a tax-deferral option that you don’t get with cash dividends.

The added opportunity for tax deferral that comes from buybacks may not seem like much of an advantage in any single year. However, the magic of compounding applies to that tax deferral. For Successful Investors, it can add up to a huge advantage over a decade or two.

Stock buyback benefits raise the value of a given stock holding in a couple of ways.

Stock buyback benefits #1: Stock buybacks raise a company’s earnings per share.

It’s simple arithmetic: buybacks reduce the number of shares outstanding. To get earnings per share, you divide total earnings by the number of shares outstanding. When you reduce the divisor—in this case the number of shares outstanding—the calculation gives you a higher figure for the company’s earnings per share. On the whole, buyers are willing to pay slightly more for a stock with slightly higher earnings per share.

Stock buyback benefits #2: When the company buys back its own stock in the market, it bids up the price of the stock. 

Tax advantages of share buybacks

When you hold a stock in your personal, taxable account and it pays a cash dividend, you have to pay tax on the dividend in the year in which you receive it. But at the same time, you have the use of the cash.

If the company instead devotes the cash to a stock buyback, you have two options:

• If you need cash, you can sell part of your holding in the stock, presumably at a higher price than you’d get in the absence of a buyback. If you do that, you’ll only pay taxes on the sale if the stock has moved up since you bought. If the stock has moved sideways or down, the proceeds of your sale are tax-free.
• Of course, if you don’t need cash right away, you always have the option of holding on to your stock until it suits your purposes to sell. That may not be until you retire—when your income tax rate is likely to be lower.

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Bonus Tip: The pros and cons of dividend reinvestment plans (DRIPs)

The funny thing is that, just as investors tend to underestimate the value of a buyback, they overestimate the value of a dividend reinvestment program (or DRIPs). They put a high value on the fact that they can reinvest their dividends automatically, without paying brokerage commissions.

DRIPs are plans some companies offer to let shareholders receive additional shares in lieu of cash dividends. DRIPs bypass brokers, so shareholders save on commissions.

DRIPs also eliminate the nuisance effect of receiving small cash dividend payments. Second, some DRIPs let you reinvest your dividends in additional shares at a discount to current prices. Third, many DRIPs also allow optional commission-free share purchases on a monthly or quarterly basis.

Generally, investors must first own and register at least one share before they can participate in a DRIP. Registration will generally cost $40 to $50 per company. The investor must then notify the company that they wish to participate in its DRIP.

As well, you can only buy whole shares through these DRIPs, so dividends paid must be greater than the share price. For example, say you receive a $35 dividend, and the stock is trading at $30. Assuming the company does not offer a reinvestment discount, you would receive one share and $5 in cash. Moreover, broker DRIPs do not allow for additional commission-free share purchases.

Overall, we think that DRIPs are okay for Successful Investors to participate in. But here are a few things to keep in mind:

• Some investors select their stock market investments solely on whether the company offers a DRIP. We think the availability of a DRIP is only a bonus, rather than a reason to invest by itself. Solely investing in stocks that offer DRIPs limits both investment choice and opportunity.
• The advent of low-cost discount brokerages and online investing has reduced the commission cost of investment trades. Thus, the commission-free investing that DRIP investing allows is less of an advantage today than it was in the past.
• Taxes are still payable on dividends that are reinvested.

DRIP investors sometimes overlook the fact that they have to pay taxes on the full dividend, even if they reinvest it. That tax hit and the loss of an opportunity for tax-deferred compounding greatly outweigh what they save on brokerage commissions.

Do you favour stock buybacks or do you think that they only boost stock prices in the short term without helping the value of the stock for the future?

Why do you think dividend reinvestment plans garner more excitement than stock buybacks?