Dividends and stock buybacks do not affect a company’s value

When you own a share of stock, you own a portion of the company. Therefore, when a company makes an initial profit, and the money in their bank accounts increases, the company increases in value. As a shareholder, that money is already yours, even though it is not in your account.

Let’s look at it from the perspective of a person who owns 100% of his company, Acme Chemical. Let’s say they make a $5 million dollar profit this year. The owner can do whatever he wants with the money: re-invest the money in the company, pay himself a dividend, or buy another company. No matter what our owner does with the money next, he is already $5 million richer. The money has been his since the day it made its way into the company’s bank account. Therefore, the choice of what to do with that money should depend only on what the best investment is. If there are no good investments (either inside or outside the company), the owner can pay himself a nice dividend and take a vacation.

So think of Acme when you read about a dividend or a stock buyback. As a part-owner of a company, you were richer once the company made a profit. What the company should do with the money once it has it depends only on what the best investment is. If the company’s stock is cheap, a buyback is a good investment. If the company can expand profitably, then re-investment in the company is a good course. If competitors are for sale cheap, then an acquisition could be good. If nothing else seems good, smart management will pay a dividend.

If, however, a company spends its profits on buybacks of expensive stocks or overpriced acquisitions, then management is being stupid. That is a good time for smart value investors to sell.

0 thoughts on “Dividends and stock buybacks do not affect a company’s value”

  1. “Dividends and stock buybacks do not affect a company’s value”

    I very much disagree with your statement. A company that repurchases stock at a discount to its value inherently increases the company’s value because management is proving that it is competent. A company with competent management is more valuable than one without competent management. Put another way, company A, which doesn’t buy back stock or even buys back stock above the stock’s intrinsic value vs. company B which buys back stock below intrinsic value. Both trade at identical valuations and operate in same industry and are otherwise identical. You can’t tell me that company A and B are equal, can you? Company B is MUCH more valuable than A.

  2. I do not disagree with you–both dividends and buybacks are nice to see. Buybacks are great when a stock is undervalued and dividends are great because they keep excess cash out of management’s hands. But neither dividends nor buybacks will turn an overvalued company into a good investment.

    My point is essentially that of Modigliani & Miller’s capital structure irrelevance principle. See http://en.wikipedia.org/wiki/Modigliani-Miller_theorem

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