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Homework answers / question archive / We have discussed that most firms return capital to their shareholders by a combination of both paying dividends and buying back shares
We have discussed that most firms return capital to their shareholders by a combination of both paying dividends and buying back shares. There are pro’s and cons of each. Some Companies only buy back their stock (companies like Gartner, of Stamford which is ticker “IT” and market cap of $14BB, or AutoZone, ticker AZO with a market cap of $26BB). The use of this “capital returned” is an alternative to the companies using their capital for organic growth (fast growing tech companies) or acquiring other assets/companies when they believe the acquisition will add EVA (Buffett’s large acquisitions of the last 2 decades are an example). Nonetheless, the decision of how this capital is deployed (grow, return cash via dividends, or return cash via buybacks) comes down to several decisions as what is the ROIC (return on invested capital for the firm) versus that of how investors value that cash (returned) in their pocket. It also involves the “image” of the corporation, tax rates, and other factors (subjective and objective). Sometimes, the decision changes or evolves over time for a company depending upon opportunities, market conditions, and the stage of ROIC for the firm (examples are numerous, but the article from 2 days ago about Buffett buying back stock speaks to just one of these corporate evolutions).
The Question: As an investor why would you prefer the company to use their cash one way or the other (amongst their choices described above), based upon your situation and that of the company?
Solution:-
It is true that investors want companies to spend their cash one way or other, whether as dividends, buybacks, M&As or organic growth. There is a very simple reason behind the said want of investors to spend cash.
Everytime a company has excess cash on its balance sheet, it's parked in bank deposits or risk free treasury bonds yielding very little returns. The cash is a part of the equity investment owned by investors and as an investor, it is not pleasant to see a part of their equity investment being parked in banks treasury bonds earning interest.
The reason an investor buys a share is because they want to take risk and earn a return on investment higher than the risk free rate. In other words, they want to invest in a business, not in a risk free asset like bank deposits. If investors wanted their money to be invested in bank deposits, they would do it themselves rather than buying shares with that money.
Investors invest in a company's share to earn a return equal to or higher than the cost of equity of the company. Due to this reason, everytime a company has excess cash on its balance sheet earning nominal interest, investors dislike that situation that a certain part of company's assets are not deployed for the purpose of earning high returns. So, they demand the management to either find growth opportunities in the business (organic or acquisition) that can generate high ROICs (cost of equity or higher) and if there are no opportunities available, than they should distribute the cash as dividends or through buybacks. If the money is distributed as dividends or buybacks, the investors can than find some other opportunities to park their money in some other business/stock.
So, depending upon the situation that the company is in, (i.e. the organic and M&A opportunities available, growth rate in the industry, ROIC that can be generated) and the situation that the investor is in (need for cash, alternative investment opportunities available, tax provisions, etc), the investors always want the company to choose the best option amongst the various ways the cash be deployed- Reinvestment in business, dividends, Buybacks.
