When/Why would a firm decide to choose one over the others with excess cash? I understand that debt reduction would probably be vilified in periods of low borrowing costs and that firms may resort to dividends/share buybacks in periods of low rates + low growth (to distribute capital back to shareholders), but when would buybacks be favoured over dividends and vice versa?
All advice is greatly appreciated!
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Here's an article discussing the merits of all three of those options http://www.valueline.com/Tools/Educational_Articles/Stocks/What_Is_Bett…
The article is interesting. Would like to get some more inputs from someone else
You missed one more - capex. Remember excess cash can generally be used towards three major categories of corporate activities - 1. capex, expansionary to be more specific, to fund growth, 2. voluntary debt pay-down, and 3. distribution to shareholders incl. buybacks and/or dividends. Aside from the technical aspect of, e.g. some debt instrument (in particular senior secured debt) requiring application of excess cash for debt repayment as part of the financial covenant, you can easily see, based on the three purposes, the application of excess cash is fundamentally driven by how to create value for the enterprise: for instance, expansionary capex to fund revenue/profit growth, debt payment to reduce interest expense/net debt (hence equity value, think about LBO), and distribution to shareholders (to the extent allowed) as a stance for shareholder friendliness which may result in growth in EPS, multiple expansion, etc.
In short, no right or wrong answer, or superiority of one option over the other.
What's the difference between "excess cash" and Free Cash Flow? As I know the formula, FCF = OCF - Capex
cash flow in excess of mandatory debt principle payments. Some debt also has "cash/debt sweep"covenants that stipulate accelerated payments on said debt are made until a mimimum cash net gain is reached
Paying down debt and distributions back to shareholders via buybacks or dividends should not, in theory, add any value to the business on an enterprise level. As DollarsKeepRising mentioned above, you should always be considering the alternative of using cash for growth capex because in theory that should be increasing the EV. Growth capex isn't always the answer, but it is something to constantly keep in mind.
Buybacks Versus Dividends (Originally Posted: 04/27/2014)
If you are invested in a company that you believe is significantly undervalued, in what case would you prefer them to pay a dividend versus buying back stock?
if the tax treatment of dividends is more favorable, and/or if I am looking for a long-term investment that will appreciate in value significantly.
Historically speaking, buybacks have been better for total returns than dividends. There are obviously caveats, like if you need income, or are buying back at a high price, but in general it's true.
Good buybacks: Henry Singleton Bad buybacks: Reed Hastings
Read The Outsiders.
Yes I have, that's why I was asking the question
You don't think the anecdotes were convincing?
Depends. Buy backs typically happen when the company feels its stock is undervalued. They will buy until some price. If their buyback price is less than your internal value over your intended horizon, you hold and enjoy the prop up in price; otherwise, the company is valuing its stock greater than you do for your time horizon, and you should sell (because you've reached your target value/price earlier) and wait to buy it again after the price (you would presume) corrects.
I'd appreciate any feedback on this thesis.
In cyclical industries, the time in the cycle when companies have the cash to return to shareholders is generally at the top, so their stock price is inherently more fully valued than average. Dividends are preferred from this point of view, independent of tax.
Agreed - There have been studies (quite recent) that have shown that buybacks have consistently (statistically significant) occurred at the worst time of the cycle.
Bottom-line - and this is my opinion mind you -
Dividends (paid out of earnings to keep the D/E ratio stable); is superior to Buybacks (which disrupt the D/E ratio).
Sitting on cash may annoy investors, but if the management are capable then it's not a bad place to be, never under-estimate dry powder. -> If they hold onto cash even at the cost of debt, then you're getting that 'interest' on cash as a tax friendly capital gain.
I agree with this. If company is really undervalued and sees buybacks as the most Accretive use of cash then it's much better than what a dividend could give you. However, most of the time what BeastMode said happens.
Exceptions where a dividend might be preferable (arguably these are all situations that aren't really 'undervalued' to begin with): - Cash rich company getting no credit for its balance sheet but a high multiple for its operations - Sketchy ADR where it'd be nice to see hard evidence the cash is really there - Company with significant event risk coming up - Income investment valued by monkeys on yield
Return of capital in either case isn't desirable even for an undervalued company if it has higher risk-adjusted return investment opportunities available, but that's often a point of major disagreement between management and shareholders.
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