Buybacks and Dividends: Sizing the Upswing

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Dividends and buybacks are set to return this year. How can analysts find out whether they contribute to a firm’s intrinsic value?

The Corporation responded to the onset of the COVID-19 pandemic by reducing costs and increasing liquidity.

In the United States, non-financial companies now hold $2.6 trillion in cash, equivalent to more than 5% of total assets. This is down from an all-time peak of 6% set last summer. Meanwhile, the net debt-to-EBITDA ratio has been significantly down over the past decades.

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US Corporate Cash/Assets

Chart showing US corporate cash as a percentage of assets
Note: Non-financial corporate; Cash includes checking deposits and money market funds.
Source: US Federal Reserve and Wealth Enhancement Group, as of March 31, 2021.

As earnings increase and the larger economy begins to recover, companies deploy their cash through capital expenditures (CAPEX), mergers and acquisitions (M&A), and return cash to shareholders in the form of dividends and buybacks. ready to do.

According to Bloomberg consensus projections, earnings of the S&P 500 will grow by more than 50% in 2021 and Goldman Sachs predicts 5% growth And 35% in dividends and buybacks, respectively.

Cashback should be a significant driver of stock returns, especially in the midst of such low interest rates. Indeed, dividend and buyback stocks began to outperform the S&P 500 in early 2021.


Buyback and Dividend Stocks vs. S&P 500

Chart showing buyback and dividend stocks versus the S&P 500
Note: Index normalized with effect from 30 April 2020; S&P 500 Total Return, Goldman Sachs Dividend Growth Basket, Goldman Sachs Buyback Basket
Sources: Bloomberg, S&P, Goldman Sachs and Wealth Enhancement Group as of May 14, 2021

While shareholders generally benefit from a cash return, the appeal and usefulness of such transactions varies by company.

The cash return should boost the intrinsic value of the firm. The question is how to determine whether a particular return meets that goal. This requires a multi-stage assessment framework that answers three questions:

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1. Does the company have potential capex, R&D, or M&A activities on which its cash could be used?

Assessing a firm’s approach to particular projects is a tricky venture: the spectrum of such activities runs the gamut and investment details are not transparent or public. Nevertheless, history can be a useful guide.

Has the company struggled in the past to generate a return on capital (ROC) greater than its cost of capital (COC)? If so, this trend is likely to continue until potential projects are markedly different from their predecessors. If the ROC is expected to be lower than the COC, the cash return becomes more attractive.

For companies with short histories, analysts may look to major capital expenditure projects, or M&A. For the former, there must be a positive net present value (NPV). For M&A to add value at the highest level, the NPV of synergies must exceed the premium paid above the target company’s intrinsic value.

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2. How much money can the firm allocate to give back?

To determine the size of the outlay a company must make to shareholders, free cash flow (FCF) production and financial leverage are good metrics to look at. The higher a company’s FCF margin, the more latitude it has to give back. An FCF margin above market and at least equal to comparable denotes strong FCF generation.

But the FCF variability also has to be assessed. Key drivers of FCF volatility include the growth phase of the corporation and the cyclicality of its sector. An early-stage high-growth company will typically have a lower and more sporadic FCF than an established firm. Corporations with revenue and profitability strongly linked to economic activity will also have more variable FCFs.

Three methods help assess a company’s debt level and whether it is overstated, undervalued, or properly leveraged:

  • Comparable: This simple approach weighs a company’s debt ratio against other firms in the same industry.
  • Downside Operating Profitability: This method determines an acceptable level of credit risk by assuming a worst-case scenario based on historical financials or forward financial projects. An acceptable level of default risk, a target credit rating, and a minimum credit ratio must be met to comply with bond contracts.
  • Reducing the cost of capital: This is the most theoretical method but helps to complete the analysis. The optimum balance of debt to equity minimizes the cost of capital and therefore maximizes intrinsic firm value. how? By identifying the minimum weighted average cost of capital (WACC) by combining the firm’s cost of debt, or interest rate, and cost of equity, or expected rate of return to shareholders, for each debt/equity mix.

By triangulating these approaches, analysts can determine an optimal leverage level.

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Combining a firm’s approach to projects with its cash flow and leverage profile can inform an overall return strategy. The matrix below represents the four mixtures:


Calibrating Cashback Capability

bad projects good projects
strong free cash flow raise giveback
reduce investment
raise giveback
Deposit cash for new investment
weak free cash flow subtract giveback
reduce investment
subtract giveback
increase investment

Note: If the firm is under or over leveraged, the giveback can be adjusted up or down accordingly.
Source: Wealth Growth Group


3. Should this return be dividend or buyback?

Determining the best form of cash return is the last step in the process. For dividends to occur, firms must have strong FCF output without undue variability and move past their fastest growth phase. The market interprets dividend changes as signals from management. This often means the introduction of dividends that the company’s long-term growth prospects have dimmed. Benchmarking against the dividend yield and payout of similar firms can provide useful insight.

The suitability of the buyback depends on the answer to the following questions:

1. Is the stock undervalued?

If an equity is trading below its intrinsic value, it is a good investment, and it makes sense to buy back the shares.

2. What is the growth stage of the firm?

If the company has passed the initial growth stage while investing heavily, it may be worth buying shares.

3. Is the firm in a cyclical industry?

If so, the flexibility to repurchase could make them better for dividends.

4. How important are employee stock options to attracting and retaining talent?

Many companies, especially in the technology sector, issue options to their employees and are required to buy back the shares to compensate for the dilution of the shares.

5. Is the rate of tax on capital gain different from that of dividend?

Tax rates vary by investor type. Currently, long-term capital gains are taxed in the same way as dividends.

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In the United States, there are legislative proposals to increase taxes on the highest-earning individuals and corporations. Political consequences are difficult to forecast, but an increase in the capital gains rate on investors to less than 1% should not materially change the buyback versus dividend decision. Raising corporate tax rates will bring down the FCF but also increase the benefit of taking more debt to build up the interest expense tax shield.

With corporate cash balances at record highs, firms are likely to continue increasing their cash return to benefit shareholders. But investors should be aware that while generally a good idea, some are better than others.

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All posts are the views of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: © Getty Images / champc


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Brian F. Lomax, CFA, CAIA

Brian F. Lomax, CFA, CAIA, is a Senior Portfolio Manager at Wealth Enhancement Group, managing a portfolio with a focus on large-cap equities and investment-grade bonds. He has been in the asset management industry since 1992 and has run portfolios with a variety of mandates. Lomax holds a Bachelor of Commerce degree from Queen’s University in Canada.



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