We’ve all heard about the mountains of cash that are just sitting on corporate America’s balance sheet, stashed away in bank accounts overseas earning next to nothing in interest. What should companies do with all that cash they have on hand?
Corporations have only a few options. They can pay down debt if they have any outstanding, but ideally, they invest in projects that have a rate of return that is greater than their cost of capital. This option is what companies try to do all the time. The problem is that many times, there aren’t any projects available to them that can reasonably be expected to earn a rate of return that is greater than their cost of capital. At the very least, they should look for projects that have a positive net present value.
What happens if they can’t find any such projects?
If no other opportunities are available for a company to deploy the cash, it should return the cash to the shareholders, but what is the best way to do this? Should it pay out a dividend to the current owners of the stock or buy back its own shares to reduce the number of shares outstanding and increase earnings per share?
A few issues definitely need to be considered when determining which of these two alternatives would be best for shareholders.
We’ll take a look at an imaginary company called “Orange.” And let’s say this company, Orange, makes a really cool product called a “You-pad” and everybody in the world just has to have one. As a result of this wonder gizmo, Orange is very profitable, has no debt outstanding, and has ended up with one of the aforementioned mountains of cash in the amount of $1 billion.
First, let’s take a look at the implications of Orange deciding to pay out a special one-time dividend. That’s simple enough; if it has 100 million shares outstanding, it could pay out a special $10 dividend to everyone. Problem solved. From the shareholder’s point of view, he gets the cash back right away, and a dollar today is worth more than a dollar in the future because of the time value of money.
In any event, the shareholder gets his money now and can choose to do with it what he wishes. One of the things he might do is buy more shares of Orange, in effect creating his own homemade share repurchase, but he could also allocate the returned cash to any other stock or asset class he desires. The very fact that he has those choices available to him has value in and of itself.
The downside of getting the cash back now, in the current period, is that taxes will have to be paid now and cannot be deferred into the future—a high-class problem but a consideration nonetheless. That issue brings up an important point: Dividends and capital gains may get taxed at different rates. If the difference between the two rates of taxation is huge, then there really isn’t a need for careful analysis.
If dividends get taxed at 90% while capital gains get taxed at 5%, shareholders will obviously prefer the lower tax rate on capital gains and will, therefore, prefer that the excess cash be used to buy back shares.
Let’s assume, for argument’s sake, that taxes and capital gains are, in fact, taxed at the same rate. Taxes should never be the only thing that drives investment decisions, but they are an important consideration because investors are looking to maximize their “real returns,” or after-tax, after-inflation returns.
What if instead of paying out a dividend, the company decides to repurchase its own shares on the open market? Share buybacks increase EPS and share price. And although buybacks are taxed as a capital gain when sold, the choice of when to sell them is up to the shareholder. Let’s say Orange is going to earn $100 million, or $1 per share, this year. Because of its growth rate and future earnings prospects, the stock is trading at a P/E multiple of 100 times earnings, or $100 per share. How many shares of stock could the company buy back with the $1 billion it has in cash?
According to my calculator, Orange could buy back 10 million shares. That would leave it with 90 million shares outstanding after the buyback. Now, just because the company buys back shares doesn’t mean people are going to stop buying You-pads, so it will still earn $100 million this year. But with only 90 million shares outstanding, its EPS will now be $1.11.
Since it is still growing just as fast, the market should still be willing to pay 100 times earnings, which would mean a price of $111, or about 11% higher, and more capital gains for investors. Note that the dividend of $10 per share on a $100 stock is a yield to shareholders of 10%, similar to the return associated with the higher per share earnings. Investors get to determine when they pay those capital gains by deciding when they want to sell shares, now or in the future.
So, which do you think is better? Let me know on Twitter at @SconsetCapital or in the comments below.