Here on the ASX, it's fair to say that dividends are a very popular feature of investing in ASX shares. Who doesn't love the passive income that a dividend-paying share can provide? But there is another way that a company can return capital to shareholders – a share buyback.
And while dividends tend to get most of the headlines, share buybacks can also be highly lucrative for investors too. So which is better: a dividend or a share buyback?
Buybacks vs dividends
Let's start with the basics. As most ASX investors would be aware, a dividend is a cash payment made by a company to its investors. On the ASX, companies usually pay out a dividend every six months, but some may pay quarterly, or even monthly.
On the other hand, a share buyback provides no immediate cash flow to investors. Instead of using profits to send out cheques to investors, a company can instead use that cash to buy back its own stock from the share market.
Because the overall share count for that company's stock is reduced, it tends to boost the company's stock price. That's because, under the laws of supply and demand, reduced supply results in higher prices. What's more, this reduced share count means all existing investors' ownership of the company is increased, and there are fewer shares to divide earnings and dividends between.
As an example, let's say I own ten shares of Company X, and there are 100 shares in total. This means that I effectively own 10% of this company, and am entitled to 10% of its profits and dividends. If Company X then decides to buy back 10% of its shares, we are left with 90 shares in total. I still own 10 shares though, so my ownership of Company X increases from 10% to 11.11%. Thus, my future returns (and potential dividend income) will rise.
So which is better for investors?
Buffett prefers a buyback
Well, Warren Buffett might argue that share buybacks are preferable to dividends. Buffett's company, Berkshire Hathaway, last paid out a dividend in 1967. But Buffett routinely engages in share buybacks.
In the 2012 letter to Berkshire Hathaway shareholders, Buffett offered an explanation:
A number of Berkshire shareholders – including some of my good friends – would like Berkshire to pay a cash dividend. It puzzles them that we relish the dividends we receive from most of the stocks that Berkshire owns, but pay out nothing ourselves…
I have made plenty of mistakes in acquisitions and will make more. Overall, however, our record is satisfactory, which means that our shareholders are far wealthier today than they would be if the funds we used for acquisitions had instead been devoted to share repurchases or dividends.
However, Buffett also notes that when there are no acquisitions available that take his fancy, it is share buybacks that are his preference:
Indeed, disciplined repurchases are the surest way to use funds intelligently: It's hard to go wrong when you're buying dollar bills for 80¢ or less. We explained our criteria for repurchases in last year's report and, if the opportunity presents itself, we will buy large quantities of our stock…
He goes on to explain that a share buyback returns value to shareholders in a manner they do not have to pay tax on. Conversely, he points out that a dividend in the US is only received after tax has been paid on it twice: once at the corporate tax level and once at the income tax level.
So for US investors, Buffett clearly thinks buybacks are preferable to dividends. But is it the same on the ASX?
The dividends are better on the ASX
Well, not quite. Here in Australia, we have our beloved franking credits system. This ensures that we only pay tax on our dividends once. When we receive a dividend from a company that has paid corporate tax in its profits first, we also get a franking credit. This is a receipt acknowledging that tax has already been paid, and entitles the investor to receive a refund for this tax when it is declared as income.
This makes receiving a dividend far more beneficial in Australia than it is in the United States.
Now, the fact remains that dividends are taxed whereas the value from a share buyback is tax-free, at least until you sell the shares.
As such, a share buyback might suit one investor, but a dividend might be preferable to another. For a young investor looking to maximise their portfolio's growth, a share buyback might be their preference. But for a retiree who depends on their shares for income, dividends might be the better outcome.
So we can probably conclude that both dividends and share buybacks are great ways to benefit from owning ASX shares, but both have their advantages and disadvantages.
