Welcome to Episode 111 of Special Situation Investing.
Last week my co-host wrote about Eagle Materials (EXP) and the concrete industry discussing the company’s effective strategy for out-sized returns. Much of EXP’s superior returns can be attributed to the repurchasing and retiring of its own shares. But what exactly makes share repurchases so effective? If a company steadily produces robust earnings does it really matter how those earnings are distributed?
On the surface, it would seem that a dollar earned is a dollar earned, and that shareholders benefit the same from both dividend and share buyback strategies. But the math behind how those earnings translate to shareholder returns can be quite staggering. Warren Buffett himself covered this topic in more than one shareholder letter, but, as with most profound concepts, it’s worth revisiting from time to time even if you’re already familiar with the topic.
To illustrate how much the means by which a company returns capital to shareholders matters, let’s investigate the same hypothetical company under two different capital allocating models. In both scenarios the imaginary company will earn $10,000,000 per year and experience no change in earnings. Next, the company will start with 1,000,000 shares outstanding in both scenarios but will see the share count steadily drop under the buyback scenario. The companies’ P/E ratio will also remain constant at five throughout both scenarios.
Scenario One
In Scenario One, management decides to repay shareholders through dividends alone. The company distributes 100% of its annual earnings to shareholders via a dividend for each of ten years. The company’s management realizes that capital can’t be effectively employed within the business, growth can’t be obtained via acquisitions or mergers, and there is no debt to repay, which leads them to the conclusion that the most shareholder-minded path forward is to distribute all of the earnings to shareholders via dividends.
Ten years of after-tax dividend distributions added to the after-tax proceeds of a share sold in the tenth year will, when compared with the starting amount payed for the first share, reveal our imaginary investor’s total return for Scenario One. For simplicity sake, a 15% tax rate will be used on both dividend distributions and the sale of stock in both scenarios.
Armed with that background information, how did our imaginary investor fare in the dividend-only scenario? We can see based on the chart below that he initially purchased a $50 share in the company that was earning $10 per share. The full $10 in earnings was paid out to investors as a dividend but of course the investor paid a 15% tax on the distribution leaving him with $8.50. This initial return sees our investor feeling pretty good about himself as he’s earned a respectable 17% on his investment in year one and was able to beat the S&P 500.
Because the company experiences no growth over a ten year period, we can easily calculate our investor earns $85 dollars in dividends over a ten year period. And because earnings and P/E remain constant, the shares still trade for $50 dollars at the end of a ten year years.
Our investor sells his $50 share at the end of ten years and nets $42.50 after paying a 15% tax which when added to his $85 in dividend income leaves him with a total of $127.50. Not too bad given his initial investment of $50 but because there was no growth in the underlying share price, and because of the effect of taxes on his investment, his compounded annual growth rate (CAGR) at the end of 10 years amounts to only 9.81%. A solid return to be sure but nothing that will land you in the fund manager hall of fame with the likes of Sir John Templeton and Warren Buffett.
Scenario Two
In Scenario Two the company returns all of its earnings to shareholders via share buybacks and pays no dividend. The management in this scenario also see that the company can’t grow internally, and that it can’t grow through mergers or acquisitions, and that no debt repayments are required. But instead of paying out earnings as a dividend, they believe shareholders will benefit most from buybacks.
In year one the company earns $10,000,000 and each of its 1,000,000 share trades for $50 per share meaning that it can use the earnings to repurchase 200,000 shares of stock. What’s interesting is how non-linear the share repurchases are with each passing year. This is because the $10,000,000 in earnings, which remains flat throughout, is divided among fewer and fewer shares outstanding so that the earnings per share rise even while the company’s actual earnings remain flat. The flat P/E multiple of five is applied to an ever increasing earnings per share which makes each share more expensive and leads to less shares being repurchased each year. The math is Occam’s Razor-like in its outcome in that you continue to buyback shares but never quite repurchase all of them.
In any case, a quick glance at the included chart shows that the company’s price per share increases exponentially under the share repurchase only strategy. In fact, the shares come close to doubling in price every three years which should set off alarm bells in the head of any investor. Doubling every three years indicates that you are in fact now approaching hall of fame level growth rates.
The precise return on investment in Scenario Two can be calculated as follows.
No dividends are paid but due to share repurchases the stagnant $10,000,000 in earnings leads to ever increasing earning per share, and an ever increasing share price, ending with a price per share in year ten of $372.54. After applying a 15% tax to the final share price the investor has $316.66 from a starting investment of $50 or a 20.27% CAGR.
The difference between Scenario One and Scenario Two is staggering, especially given that the company’s fundamental performance didn’t change in either case. To further highlight the difference, it’s worth noting that $10,000 invested in Scenario One would end up as $25,492 in ten years while in Scenario Two an investor would end up with a whopping $63,325. More than double the total return in Scenario Two given no other variable than the capital allocations decision of management.
Retained Earnings Valued Higher Than Dividends
One key reason buybacks yield higher returns than dividends is because retained earnings are multiplied by the price to earning multiple which, in effect, makes each retained dollar worth more to the investor. Let’s use the company in our previous two examples to illustrate the point. We see that a single dollar of earnings, if retained, can be sold for $5.00 because it is multiplied by the P/E ratio of five. While the $1.00 in earnings as a dividend is worth less than a single dollar because no multiple is applied, and the 15% capital gains tax applies to it, leaving the investor with only $0.85.
As more shares are repurchased the company’s earnings per share also increase which further compounds the benefit of retained earnings mentioned above. Put simply, retained earnings are worth more, all else being equal, than earnings payed out as dividends. Share repurchases compound this effect by increasing the multiplier with which the already superior retained earnings are multiplied.
Real-World Complications
Of course nothing in the real world is ever so static as the simplistic examples used in today’s discussion. Multiple variables can effect results in either direction. For example, paying out a large dividend can by itself drive the stock’s price higher. This is because the high dividend yield of the stock might attract other investors seeking steady income and their purchasing of the stock could drive the price higher. In both of our scenarios, the P/E multiple remained flat at five but a sizable and steady dividend payment could increase the price of the stock and in turn increase an investor’s CAGR in that circumstance.
Furthermore, a combined strategy of dividends and buybacks can be applied to the same company. The capital allocation decisions of management don’t have to be fully dividends or buybacks as outlined in the scenarios above but could be a combination of both.
Interestingly, a static dividend payout when combined with share repurchases, will result in an ever increasing per-share dividend without having to increase the actual dividend payout at the corporate level. In this case, share repurchases would both increase the stock’s earnings per share and its dividend payout and would have a different overall effect on investment performance than either scenario would in isolation.
One key to remember, in the case of the buyback scenario, is that the total share count must go down over time. Many companies virtue signal by engaging in share buybacks only to turn around and issue the same shares in the form of executive stock compensation. In this case the share repurchase doesn’t benefit you, the owner, but rather underwrite the executive suites compensation package. A consistent policy of share repurchases should see the company’s total shares outstanding shrink commensurately over time if the investor is to have any hope of securing the benefit of the buybacks in the form of investment returns.
One Size Doesn’t Fit All
It should be remembered that there is no-one-size-fits-all strategy in investing. If a company can compound capital through internal investment at a higher rate than it could through either dividend payouts, or share repurchases, then it should take that course. The end goal should be the highest CAGR for investors regardless of the tactics used to accomplish the goal. But for some companies, compounding capital internally isn’t an option, and deciding what combination of dividends and share buybacks to pursue is of the highest importance to shareholders.
Many of the companies we review on this podcast are in just such a situation. Orphaned by ESG policies many natural resource companies are cut off from traditional financing and growth opportunities. These companies earn high returns on capital employed but have limited means by which they can internally employ the capital they produce. Understanding the math that drives shareholder returns for both dividend strategies and share buyback strategies can help investors determine which companies are most intelligently managing the hand they’ve been dealt and which companies will yield the highest return to investors.
Conclusion
With that we hope you’ve enjoyed today’s show and that you’re learning along with us as we share our own investment insights with you in real time. If you like the show and the information we provide, you can always support us with a boost on the Fountain app or leave us a review on whatever app you use to listen to podcasts. We can’t thank you enough for the fantastic interactions and insights you’ve share with us and we look forward to bringing you another episode next week.
The Mathematics of Buybacks and Dividends