Forget Living Off Dividends - Buybacks is What Smart Investors Prefer
Have you ever wondered why Berkshire Hathaway doesn't pay dividends? Why do people like me don't like receiving dividends in taxable accounts?
In this video, I'm going to explain the reason why I prefer the companies I own return money through buybacks instead of dividends and why you should too. And at the end of the video, I'll be giving away six months of premium membership to our newsletter to the first 10 People who can tell me the amount of buybacks that Berkshire Hathaway did in 2021. Just post the answer in the comments below.
Welcome to the Always Be Compounding Club, where we share ideas on how to build, grow and enjoy wealth. For those who are new to the channel, I'm your host, Dennis Chen. I'm a full time investor, entrepreneur, financial book author, Wharton MBA and CFA Charter holder. Welcome aboard.
Businesses can do four things with their profits:
- One, they can reinvest them in the business.
- Two, they can do acquisitions.
- Three, they can distribute them to the shareholder as dividends
- Four, they can buy back shares
Let's define dividends. Dividends is a distribution of profits to shareholders that are usually paid out in the form of cash. Many investors prefer buying companies that pay dividends because having a dividend is a sign of a profitable and well managed company. Another reason is, that it's harder to fudge accounting numbers. Three, it keeps management focused and honest. And four, investors receive the actual cash. Examples of companies that pay dividends or AT & T, Johnson and Johnson and Coca Cola.
Let's define, what is a stock buyback. Buyback is a way to distribute profits back to owners. The company buys back stock from the public and it takes it out of circulation. This increases the value of the remaining stock if the buyback is done right. By reducing the amount of stock available in the market, the earnings per share increase.
There is a caveat to buybacks though. There's what I call good buybacks and bad buybacks. If done right, buybacks increase value to the rest of the shareholders that remain in the store. Wrong buybacks actually destroy value.
Here's an example of a good buyback. Let's say that we own a lemonade stand that has a book value of $100. And there are five shares. And there are five partners, each owning one share of $20. If one of the partners wants out and offers his share up for sale for $10, and the company buys it back, then the remaining book value of the lemonade stand would be $90, which is $100 minus the $10 that was used to pay for the buyback of the share. So now, there are four shares left or outstanding. So now the book value of each share is $22.50, which is $90 divided by four. Therefore, by doing the buyback, the book value of the share went up from $20 to $22.50. That's a good buyback.
Now let's see what happens when you do a bad buyback. Same scenario, the initial look value is $100. And there are five shares. So each share is worth $20, assuming we use book value as the evaluation method. Now, if one of the shareholder offers a share for $30, and the company pays it, which means that they paid above the book value, then the remaining book value of the company would be $70, which is $100 minus the $30 that we paid during $70. Given that there are four shares outstanding left, the book value per share of the remaining shareholders is $70.50, which is your fair share from $20 to $17.50.
Now let's take a look at how buybacks increase the earnings per share. This is how it works. Let's say that the lemonade stand was making $20 and there are five shares outstanding. That means that each share is entitled to $4 of profit, that's $20 of profit divided by the five shares. However, after a buyback of one share, there's only four shares outstanding. Now each share is entitled to $5. That's $20 divided by four. So your profits per share or earnings per share increased because you have one less partner to share your profits with.
Rational investors prefer good buybacks because they increase stock value to allow for automatic reinvestment and automatic compounding, and good buybacks are tax efficient. It allows investors to defer taxes. The profits keep compounding within the business, and they only pay taxes on capital gains when you sell the stock. So the investors can control the timing of the taxable event. With dividends, you have to pay taxes not every year, but whenever dividends are paid.
Examples of companies that are doing buybacks are Apple and Berkshire Hathaway. Berkshire Hathaway has been buying back shares in the past year or so. Returning money to shareholders last year in 2021, Berkshire bought back $27 billion worth of Berkshire stock.
Let's look at an example of tax efficiency. If you had invested $1,000 at a 20% annual return rate, here, you'll see the difference between a stock that doesn't pay dividends and yet compounds versus one that pays dividends and dividends are reinvested. After 20 years, the difference is close to $10,000. That's the effect of being taxed every year, once on the dividends that are paid, versus just paying taxes at the end while your profits compound annually for over 20 years and you pay your tax at the end of the 20 years when you have your capital gains. Rational investors like me prefer good stock buybacks. So when Berkshire Hathaway buys back stocks when it's undervalued, I'm a happy camper.
What happens when a retired person needs regular dividends? That's easy. In this case, oh yes, create a synthetic dividend program. This is where you sell a percentage of the portfolio every quarter or every year. For example, if I needed a 4% dividend out of my position, I would sell 1% of the position once a quarter.
By the way, another option would be to sell covered calls against the stock. I'll do a separate video explaining the covered call strategy. This gives the investors the option to take dividends when they need them, and not take dividends if you just want to continue compounding your wealth. This provides a lot of flexibility. The only prerequisite to this is that the stock has to have enough liquidity. Stocks, like Berkshire Hathaway are pretty liquid and traded on the New York Stock Exchange.
There's been pushback lately by the political class saying that buybacks are bad. It is perceived to be bad by some of the political class. However, you've seen that good buybacks are very good for the rational investor. So the reason that they oppose that is because they just want to charge taxes now, versus waiting and be partners in the compounding effect, and getting new taxes later. Anyways, you'll either pay your taxes now or you pay it later. Most likely, if you pay later, the government will earn more because they're your partner in growing your portfolio.
So there you have it. Good buybacks are better than getting paid dividends. If you have any more questions, feel free to place them in the comment section below. And by the way, remember that I'm giving a six month premium membership to the Always Be Compounding Newsletter. So the first 10 people, how much did Berkshire Hathaway buy back last year? I mentioned that number previously in the video.
So thank you very much for watching. Have a great day and you remember to always be compounding. So long. Take care.