Building wealth: Here’s why I prefer ASX share buybacks to dividends

When ASX shares want to return capital to their shareholders, they typically have two choices. The first, and most beloved, method is by paying a dividend. The second, undertaking a share buyback program.

Dividends are easily the preferred method of capital return for most ASX investors. That’s understandable. After all, nothing quite compares to that feeling of receiving cold, hard cash in return for a past investment.

Share buybacks don’t involve a direct transfer of wealth from the company to the investor. As such, many investors prefer that a company pay out a dividend if it has money to spare. But I would prefer most of my investments to undertake buybacks. Let’s talk about why.

Share buybacks vs. dividends

Buybacks and dividends are similar in origin. Both can only be undertaken, at least sustainably, if a company is healthily profitable. And both methods benefit shareholders, obviously. But that’s where the similarities end.

Dividends represent one-off cash payments, with that cash taken directly out of the company’s bank account. Dividends are fantastic for shareholders, but it is important for investors to recognise that they inherently weaken a company. That cash that is paid out in dividends can only be used once. Once it is paid out, it cannot be reinvested into the business or used to pay down debt.

Investors should keep this in mind. If a company is choosing to use its cash to incentivise shareholders at the expense of paying down high-interest debt or investing in lucrative business opportunities, if possible, then shareholders are likely to suffer down the road.

Share buybacks involve using a company’s cash to purchase its own shares from the open market. Once these shares are bought, they are destroyed. This reduces the company’s overall share count, and thus boosts the ownership stakes of all remaining shareholders.

If done correctly, I think share buybacks are more beneficial to both shareholders and the company than paying out a dividend.

This is because a share buyback program offers investors ongoing benefits, while a dividend payment does not. Once a dividend has been declared and funded, that cash goes out the company door, never to return and never to benefit the company again.

But in the case of a share buyback, that reduced share count is a permanent change to the company’s investment profile. For the following year, as well as all years that come after, that reduced share count stays. This means there are perpetually fewer shares to divide earnings and profits amongst going forward, meaning earnings per share (EPS) will enjoy an everlasting boost from the reduced share count. Further, there are now fewer shares to pay dividends to going forward, meaning any future dividend declaration will be cheaper for the company to fund.

When do share purchases make sense?

So it’s for this reason that I would prefer to see most of my ASX shares use their cash to fund share buyback programs rather than larger dividends.

There is one caveat to this, though. That would be pricing. Like you or I, companies that buy their own shares usually have to do so at market pricing. The efficiency of using the company’s own funds to buy back its shares is higher when the company’s valuation is lower, and vice versa.

Buybacks only benefit shareholders when they are done at compelling valuations. If I saw that Commonwealth Bank of Australia (ASX: CBA), for example, was buying back its own stock when it hit $193 a share last year, I would regard it as an exceptionally poor use of capital, given how expensive its shares were, relative to its earnings, at that price.

If CBA undertook a buyback when its shares went under $90 each back in 2022 though, I would have been in full support.

Like all investors, companies should only buy shares when the prices make it an attractive long-term investment. If they can do so, I’ll take it over a dividend any day.

The post Building wealth: Here’s why I prefer ASX share buybacks to dividends appeared first on The Motley Fool Australia.

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Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.