Don't let taxes impair your judgment
Far better to have profitable investments and pay taxes than to lose money trying to mitigate them
I have had a lot of comments on Twitter from generally inexperienced investors who say they prefer stock buybacks to dividends since the dividend will attract taxes and the buyback will not, at least not until they sell their stock which they believe will be at a gain enhanced by the effect of the buyback. This is misguided in the case of Canadian investors.
Dividends from profitable Canadian companies are called “eligible” dividends and benefit from a dividend tax credit (DTC). For ordinary Canadians earning less than $50,000 a year, the DTC means the investor will pay little or no taxes on the first $60,000 of dividend income in a given year. Not so with capital gains, where half of the gain is taxed as ordinary income. Dividends and capital gains are taxed at close to the same rates at $81,000 of annual income above which capital gains benefit from an effectively lower tax rate. For Canadians in the lowest tax bracket, taxes on dividends are actually negative in most Provinces.
Investors earning less than $100,000 a year should prefer dividends to capital gains. Here is the combined Federal and Provincial tax burden for Ontario residents by income category posted by an Ontario Law Firm.
The other factor to consider is certainty versus risk. Once a dividend is declared and paid, the investor gets the cash and pays the tax (and for those earning less than $48,535 that tax is zero). That is a certain outcome. For a share buyback in the equivalent amount, the investor is at risk to the future price of the shares in which they have invested, and may get a capital gain or suffer a capital loss. The current surge in buybacks of energy stocks is premised on the belief the stocks are undervalued and the buyback improves the value of the shares remaining.
Or does it?
In the cases of both dividends and buybacks the money leaves the company. In the case of dividends, the investor can reinvest the after-tax dividend in shares of the company if they share the view the shares represent good value but in the case of buybacks that decision is being made for them by management. It is a reasonable presumption that management buying back shares believes they do not have better uses for the cash internally and that the implicit return on the shares repurchased is greater than the return on investment if those funds had been reinvested in the company’s capital program. The energy sector in Canada today has free cash flow (FCF) approximating 20% of Enterprise Value (EV) which is the sum of existing debt and the market capitalization of outstanding shares.
Both buybacks and dividends imply that the company management believes it does not have investment opportunities that can generate a pre-tax return greater than 20%. If that is truly the case with oil prices north of $100 a barrel and natural gas prices at 10-year highs, then the prospects for the company cannot be robust. Management’s decision (if taken in good faith) must reflect a belief that the current firm commodity prices are temporary and do not warrant the risk of greater investment in the business. But management may be motivated in buying back shares by another metric - short term share prices or earnings per share which feed into the value of their stock options, RSU’s and bonuses. Buybacks are an artificial way to boost net income per share in the immediate future. They may be motivated by benefits to management rather than returns to shareholders.
McKinsey & Company, Inc. (full disclosure, I used to work for McKinsey) published a study in 2016 entitled “How share repurchases boost earnings without improving returns”. It is worth taking time to read.
For those young investors who have made comments on Twitter about why they prefer buybacks to dividends, I encourage them to speak to a tax professional and to consider whether in their personal circumstances that it is in fact the case they will be better off as a result of their decision. If they have their investments in a Tax Free Savings Account or a Registered Retirement Savings Account, the immediate tax consequences may be irrelevant but the economic consequences will still matter.
In summary, buybacks are not “returning cash to shareholders” but are simply cashing out some shareholders and leaving the rest at risk to the future trading price of the shares they own.
Imo it is always better to return profits (via dividends) to the investor to provide them the decision of what to do with the money.
this is missing a BIG BENEFIT of buybacks over dividends, especially in stocks that are yielding 20-30-40% FCF yields. buybacks are PRE TAX funds that can be utilized to buyback shares, whereas dividends are taxed (again) by the government once issued to shareholders. For most shareholders who may buy more shares anyways (myself included esp at FCF yields of 30-40%), why would ANYONE want a dividend blows my mind especially when buybacks make my shares more valuable over the long run
If Suncor can buyback 20-30% of their shares over the next few years, I'd MUCH prefer that over a variable dividend that I would reinvest in shares anyways