The Bitter Truth About Stock Buybacks

by on August 15, 2012

in Public, Value Investing Tips & Articles

Monster Beverage Corp., (MNST) stock was brought to my attention yesterday as a potential investment due to its fast growth and increased share buyback program. I am going to take this stock as an example to illustrate why company management is often misguided when they buy back their own stock.

Stock Buybacks can Destroy Value

If you are a shareholder, you generally welcome any share repurchase announcement. The math is simple, you think.

If the company remains valued at the same level in the market, the less number of shares this value is divided by, the more the value of the remaining shares. It is a way of engineering a higher share price.

What most investors forget to take into account is that the company is using its own cash up to buy these shares back.

These shares do not magically disappear.

So while the numbers of shares do decline, the intrinsic value of the company also declines.

And not to mention any returns that the company could have generated if it had used that cash in alternative projects.

They are Not Always the Best Use of Cash

A shareholder should demand that the company they have entrusted their capital to uses it wisely. This means investing each dollar in projects that maximize the return on the capital.

When a company decides to buyback their own shares, they are indicating that the valuation is so distressed that investing in own shares are likely to generate better returns for the company (and the shareholders), then pursuing any other projects in their normal course of business.

They better be certain that the stock is undervalued by the market.

And they also need to be certain that there are no other better opportunities to use their cash.

There is no point paying $1.50 or $2 for an asset that is worth just a dollar.

You are better off parking the excess cash in treasuries and your shareholders will be richer for it.

Monster Is Going to Overpay for its Own Stock

Monster stock sells at a Price/Earnings multiple of almost 33 and a Price to Book ratio of 8.7. The P/S ratio is over 5. Not exactly in the value territory.

Put it another way, an investor looking to invest in MNST today is looking at an earnings yield of 3%. To point out my obvious problem with this, it indicates that equity in Monster is less risky (due to the perceived and hoped for growth, no doubt) then the AAA rated Microsoft corporate bonds maturing on Oct 1, 2040 that currently yield 3.961%

Maybe energy drinks are the future and more important for the humanity then a company that creates software and systems that power most of world’s governments and businesses.

I doubt it.

The growth argument does not hold water either. If the company expects a continued double digit growth, there is no reason for it to invest in its stock yielding so little. It should invest in growing its business.

You may well ask if a company has excess cash that it doesn’t need, why they should not return it to the shareholders?

Fair question. The company does have $870 m in cash and generates more free cash every quarter. If they want to return a part of this to the shareholders (the stock buy back authorization is for $500 million), all the power to them.

Just pay dividends, regular or a special one time dividend.

It is a fair 1-1 exchange. Every $ in dividend payment transfers the same $ in value to the shareholders.

Income Taxes Should have Nothing to Do with Buyback vs Dividends Decision

The argument about the income tax treatment of the return of capital is something the company should not concern itself about. If that is the argument here, the tax impact is still much lower than the value destruction in buying back an overvalued stock (assuming a 10% incremental tax impact on capital gains vs dividend taxes, the over valuation in this case is comfortably more than 10%). The fact is, most investors have their own tax plans, and quite a few own shares in their tax deferred plans where the tax argument has no merit.

A Lot of Other Companies Make this Mistake

The fact is, top management of a company is not impartial. They always overestimate the future prospects of their company and generally tend to believe that their stock is undervalued, at any price. Worse, a company maybe under a mistaken belief that their mandate is to support the stock price and not growing shareholder value

It all boils down to whether the management is short term focused or is looking after shareholder’s interest for the long term.

Bottomline: Look at Share Repurchases with a Critical Eye

Share repurchases can create value or they can destroy value. They are a great leveler and act as a catalyst to propel the stock price to the true value in the market. If the stock is currently undervalued, it means it will see an appreciation. If the stock is currently over valued, it will eventually decline as the value destruction becomes clear subsequent to the ill-advised stock buy back.

In any case, they also indicate if the management is fully grounded or if they have lost touch with reality.

(In case you are still wondering what my opinion is about investing in MNST, don’t do it)

Leave a Comment

AAAMPblog August 16, 2012 at 5:11 pm

I agree; buybacks are overrated and overused. However, I do think that company should consider the fact dividends are taxed. If a company with excess cash can buy $1 worth of assets for $1 or less then it may be to the advantage of the shareholder to do a buy back. Buybacks should ONLY be done when the valuation of a stock is depressed below it’s intrinsic value.

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ShaileshKumar August 16, 2012 at 9:05 pm

 @AAAMPblog Management’s perspective of the intrinsic value is often not objective so they make sub optimal decisions. We will disagree on considering the dividend taxes but that is alright :-)

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simbamara August 16, 2012 at 9:18 pm

@arohan Rio Tinto bought back millions of shares at over £ 4-4.4 and the price today is £3.05(been as low as £2.75).Go figure !!!

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arohan August 16, 2012 at 9:31 pm

@simbamara I think companies that have their profitability tied to the commodity markets should just stick to paying dividends

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arohan August 16, 2012 at 9:33 pm

@simbamara They are typically flush with cash when the commodities are high and their stock price is inflated

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simbamara August 16, 2012 at 9:36 pm

@arohan I have recent examples of companies issuing bonds(borrowing from market)while continuing to buy back shares !!!!!

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arohan August 16, 2012 at 9:40 pm

@simbamara Sometimes this can be a way of recapitalizing the company (changing debt-equity ratio) since debt is cheaper financing

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arohan August 16, 2012 at 9:40 pm

@simbamara And it could be fine if the buy backs are done at a reasonable price and the company is not already highly leveraged

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simbamara August 16, 2012 at 9:43 pm

@arohan Of course if the share price is clearly undervalued,buy back is an option,as often co’s do not have a clue how to invest excess cash

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simbamara August 16, 2012 at 9:21 pm

@arohan Sceptics would also say share buybacks are managements way of enhancing their bonuses.

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arohan August 16, 2012 at 9:29 pm

@simbamara Anil, the sceptics would be right in many cases

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simbamara August 16, 2012 at 9:38 pm

@arohan Non Executive board ignores this aspect as they are in it for their own bit of bone.Screw the ordinary shareholder !!

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arohan August 16, 2012 at 9:42 pm

@simbamara True, but shareholders are also complicit in this since very few raise an eyebrow when share buybacks are announced

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arohan August 16, 2012 at 9:44 pm

@simbamara The problem is that majority of the voting stock is held by “non-voting” institutions such as mutual funds

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arohan August 16, 2012 at 9:45 pm

@simbamara A widely held stock can be majority owned by various index funds that care even less about shareholder issues

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simbamara August 16, 2012 at 9:45 pm

@arohan Shareholders are lethargic+even if active,unless the institutions support them(who play golf with management:)),they cannot do much.

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simbamara August 16, 2012 at 9:46 pm

@arohan Exactly,as they are all in the same racket !!

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arohan August 16, 2012 at 9:50 pm

@simbamara :-) Shareholder control has absolutely weakened as passive fund investing grew in popularity

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simbamara August 16, 2012 at 9:24 pm

@arohan Tax on dividends argument is not full proof.Lot of non tax paying pensioners+funds depend on dividend income for their survival.

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arohan August 16, 2012 at 9:36 pm

@simbamara I think the argument should not even exist for the management. Shareholders do their own asset plans based on their situations

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rwohlner August 18, 2012 at 9:41 am

Excellent post, I sometimes wonder if companies are looking to get favorable press by doing these buybacks vs. focusing on what I consider to be the job of any public company’s management, building long-term shareholder value/wealth.

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ShaileshKumar August 18, 2012 at 3:03 pm

 @rwohlner Roger, you may be right. Sometimes, it may just be doing it for the sake of doing something. A better signal to the market would be if these buybacks are accompanied by insiders buying in the open market in their own accounts. Thanks for dropping in :-)

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pbanik August 20, 2012 at 6:04 pm

This type of buyback is akin to a central bank buying its’ own currency just to prevent it from devaluing too quickly, and there is no logical reason to do so. You made an excellent point when you point out this stock is overvalued, and therefore, it would not be in the best of management, or the shareholders for the company to utilize cash in such a frivolous manner. The Price/Sales and Price/Book are very high relative to other stocks in the market.
http://finance.yahoo.com/q/ks?s=MNST+Key+Statistics It would have to drop to about $20/share before I would consider investing in it.  Even in its’ industry, this stock is trading at a premium.
http://financials.morningstar.com/valuation/price-ratio.html?t=MNST&region=USA&culture=en-US If you look at the valuation metrics, this stock isn’t worth owning right now.  EPS is $0.62/share compared to $0.48/share a year ago in Quarter 2.  This represents a 29.2% increase over a year.  The management isn’t clearly concerned about the shareholders, judging from their lack of judgment by buying back their own shares when they’re overvalued. If they want to buy back their own shares, management should wait until the shares become more reasonably priced. 
 

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ShaileshKumar August 20, 2012 at 9:38 pm

 @pbanik Paul, you make an excellent analogy between this and propping up a currency. Ultimately, it is the fundamentals that support the valuation and most of the times the management is better off controlling what they should, viz. the fundamentals. Share repurchases make sense on only rare occasions.

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pbanik August 26, 2012 at 11:18 am

 @ShaileshKumar  I agree Shailesh. I think it makes sense if the management is trying to increase value for shareholders, or management is buying the shares at a discount to its’ true value.

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arohan August 21, 2012 at 1:10 am

@minedah Thank You Amin for the tweet! Hope you waited on the Facebook stock. Still expensive (via commun.it)

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robblackshow August 21, 2012 at 12:36 pm

@irondragonfly8 I prefer dividends but buybacks can be nice for companies with consistentcy which sadfly Best Buy doesnt have

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arohan August 22, 2012 at 8:41 pm

@AAAMPblog Thank you for the tweet! Really appreciate it

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MikeTsangaris September 4, 2012 at 7:40 pm

An article by the WSJ quickly proves this point with an article on BBY, aptly named: Best Buy’s Buybacks Haven’t Always Been Best Idea (http://blogs.wsj.com/deals/2012/08/22/best-buys-buybacks-havent-always-been-best-idea/) which Jim Cramer humoured that the company “bought a hundred million shares of itself at a very high price and now doesn’t want to buy any more down here” (episode 08/21/12) which as of that recording slumped to -33% off its YTD high of ~$28.
 
As @arohan stated, the better signal to buybacks is from signals from management that they have conviction in their company and buy shares in the open market. Looking at Form 4s, the only buy that was made was by the director on August 15, with 88 shares! (http://www.sec.gov/Archives/edgar/data/865752/000114036112037486/xslF345X03/doc1.xml) The buy before this was August 19 2011, with the amount of 33 shares. Between those two transactions, shares have been sold in the open market with the #shares ranging from 4 digit sizes to 8 digit sizes; don’t forget I’m referring to share quantity not value! I know there are many factors to consider than the black and white facts of buying and selling shares in the open market but I’m using it for the purpose of my argument.
 
To further prove the point against stock buybacks, which as a dividend seeker I am not a fan of, is in Aswath Damodaran’s “Value Investing: Investing for Grown Ups?” (http://pages.stern.nyu.edu/~adamodar/pdfiles/invphiloh/valinv.pdf?q=value) on page 47, where he charts the stock buybacks and dividends of US firms between 1989-2010, the highest amount of buybacks were made in 2007 and were increasing yearly up until that year where stock prices and valuations were at their highest and after the credit crisis in 2009, buybacks were a fifth of the 2007 high. I need not explain further.
 
On the contrary, to support @AAAMPblog’s argument that buybacks should only be done when the valuation of stock is depressed with an example, a company that is executing the buyback program right is AIG which is buying back shares at 40% discount to their book value (http://www.thestreet.com/story/11679363/1/johnson-swinging-away-at-aig.html).

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ShaileshKumar September 4, 2012 at 8:24 pm

 @MikeTsangaris  @arohan  @AAAMPblog Mike, great references. I just had a great conversation with some one where I made a point that insiders may have a slight information edge over the rest of us on purchasing their own stock (on personal accounts), but even then you have to be careful to remove the biases they might have. It is a signal to support your thesis, but nothing more and should never become a key basis for your investment thesis.
 
Re stock buybacks, I am appreciative of all the comments this post has received and it looks like many of us have long suspected that in many cases stock buybacks are more of a PR tool than a tool to enhance shareholder value. There are legitimate uses of buybacks but to my dismay the companies that do it right are exceptions rather than the rule.

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Mind Secrets November 24, 2012 at 7:23 am

I invest to stock for about 8 years,the 1st time to hear about this,thx for you sharing.

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Al August 24, 2013 at 8:30 pm

Hello Shailesh,

Using your same argument, issuing dividends when shares are highly valued is also value destroying, separate from the tax inefficiency. Imagine that a company repurchases its shares in proportion to each shareholder’s percentage ownership of the company. Shareholder’s receive cash and their ownership of the retained assets of the company remains the same. It looks like a dividend except that you only pay taxes on your GAIN, as opposed to a legally defined dividend in which your basis is treated as zero.

So a dividend and a buyback program are logically the same given certain idealizations. However, there are differences in real world execution, but these practical differences in application, rather than some inherent difference. For example, buybacks rely upon the company’s price management, and there is a communication lag between reports. Dividends lock in the price to the range of the realizable prices on the day the dividend is received. My guess is that the confusion between buybacks and dividends arises from the improper direct comparison of dividends to buybacks. That is apples to oranges. A dividend should be compared to a buyback that is immediately followed by a sale to return the share ownership to pre-buyback levels. Alternatively, a buyback can be compared to a dividend that is immediately re-invested.

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Shailesh Kumar August 24, 2013 at 9:57 pm

Hi Al,

In your idealized scenario, yes a dividend is identical to stock buyback (tax considerations aside).

However, do not forget that we are looking at the investment from the perspective of the investor who continues to hold the stock. Practically, the buyback changes the ownership of the remaining shareholders and these remaining investors are the ones who are going to feel the value destruction (not the ones who sold their shares to the company, they were smart and sold an overvalued stock). In real life buybacks cannot be applied in the same proportion as the stock held by each investor, so the equivalency you propose breaks down. In a way, the remaining investors end up subsidizing those who sell their stock to the company when the buyback is executed (in case of over valued shares).

Coming back to your idealized scenario, I want to point out one more detail. From the perspective of the company considering a buyback or a dividend, both scenarios look the same. It is cash out with no change in the ownership structure. For the investors, again in the idealized scenario, the effect is mostly the same, except in case of a dividend the investor has a choice of reinvesting or not in the overvalued shares of the company. This choice is taken away when the company does the buyback.

Tax considerations tend to complicate this further since you have to start looking at the tax rate differential (cap gains v. dividends) and whether the level of overvaluation justifies preferring one over the other. I propose that this decision be left on the investors and the companies should not take it on themselves to decide what is right. After all, there is tremendous amount of investment capital sitting in tax deferred accounts where this point is moot.

Regards and appreciate your thoughts.
Shailesh

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Al August 24, 2013 at 11:17 pm

The point of the idealization is not to show that the assumptions are true. It’s to emphasize that the differences between stock buybacks are due to informational lags and trade execution, rather than to some inherent difference between buybacks and dividends.

For example, you say: “Practically, the buyback changes the ownership of the remaining shareholders and these remaining investors are the ones who are going to feel the value destruction (not the ones who sold their shares to the company, they were smart and sold an overvalued stock). In real life buybacks cannot be applied in the same proportion as the stock held by each investor, so the equivalency you propose breaks down.”

However, you are ignoring the conditional state of being a “remaining shareholder” and thus improperly comparing such shareholders to an alternate timeline where shareholders received dividends. If you start with remaining shareholders as a given, then the comparison should be to dividend receivers who reinvest in the company at prevailing prices. Alternatively, you would compare a dividend receiver to shareholder who, post-buyback, sells his position to return to the earlier percentage ownership. Thus, I disagree with your subsequent statement, “For the investors, again in the idealized scenario, the effect is mostly the same, except in case of a dividend the investor has a choice of reinvesting or not in the overvalued shares of the company. This choice is taken away when the company does the buyback.” In fact, when a company issues a dividend, they are taking away your choice to efficiently retain a greater interest in the company. The dividend is equivalent to a mandatory participation pro rata buyback program. The only difference is that, in order to reinvest, you must pay taxes as if you had sold shares with a zero cost basis. A buyback gives you the option to retain greater percentage share ownership OR to return to the pre-buyback ownership, but with a taxable basis at your purchase price. The dividend restricts your tax planning by shunting your status into the dividend category vs. reinvestment/hold position + capital gains.

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Shailesh Kumar August 25, 2013 at 1:26 am

Al,

I am trying to figure out where we disagree. For example, you write:

“In fact, when a company issues a dividend, they are taking away your choice to efficiently retain a greater interest in the company.”

I do not think this is true when all shareholders are paid the same dividend, their relative ownership or interest in the company does not change. If half choose to reinvest in additional shares and half do not, then investors who reinvest increase their interest in the company by making the choice that the dividend imparted to them.

Perhaps I am beating around the bush in articulating so I will say it plainly thus:

When shares are overvalued, dividends are superior way of returning wealth to the shareholders as it lets the shareholders invest the dividends in another asset which is not over valued. Doing a buy back does not give this choice. Sure, the shareholder may choose to sell some shares to return to the pre-buyback level of ownership but most investors will not give this matter a second thought. It is only when they have real cash sitting in their accounts (via dividends) that they start to think how to deal with it.

I understand your point about different tax implications and these can be substantial and can definitely swing your preference from dividends to buybacks. This calculation will be different for each investor and will be based on

a. How much overvalued the stock is.

The potential decline in stock prices may actually be enough to wipe out any tax advantage you may have from the buyback over dividends. A buyback DOES NOT always raise the nominal value of the remaining shares. Mathematically it should, but in these cases it can trigger revaluation of the assets as investors take this as a signal that management considers an over valued stock as a better ROI investment than any other growth opportunities they may have with their product or service. I know I will sell all my shares if the management choose to do a buy back when the multiples are already high, and most other sophisticated investors will do as well. With the dividend cash, I at least know that every dollar I received as a dividend will retain its nominal value.

b. Whether the investor holds his shares in a taxable account or in a tax advantaged account.

Today most stock market investments in US for retail investors are made through 401Ks and IRAs via funds and annuities or company stock investment programs and it is unwise for companies to focus on tax implications when for majority of the investors it is a moot point.

c. We forget the relative values between dividends and capital gains and that may make all the difference

Should you pay 30% tax on your dividend (lets say 5% yield)? Or is paying a 20% capital gains rate on the stock which has returned you a 10% profit better, if you sell post buyback? If you purchased the stock at $100 and current price is $110, your 30% tax on $5.5 worth of dividend is $1.65 whereas a 20% capital gains on $10 profit is $2. For some other investors, the profit may be larger than 10% and for many others it will be smaller. The point is, we do not know and neither does the company

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Shailesh Kumar August 25, 2013 at 1:45 am

If I invest in your company, I want you to focus on investing the idle cash in projects that generate the highest ROI (and that is definitely higher than your cost of capital)

- If buyback is such a project, because the shares are undervalued, so be it.
- If there are no such projects available and shares are overvalued, give me the cash as a dividend and I will find another investment that can potentially reward me better. I would rather the cash sits in my bank account than yours, just in case I can’t find a better investment (I am more likely to find it though compared to you since I am not focused on a narrow sector like you are)

And I will do my own tax planning because my situation is different from the “average”.

Sometimes it is that simple.

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Al August 25, 2013 at 3:58 pm

Shailesh,

We are circling back to my original post arguing that dividends are equal to buybacks except for execution issues, lagged information, and tax implications. Any argument that a buyback should not be undertaken at overvaluations is pretty much the same as one that argues against dividends at higher prices.

First off, you say: “I do not think this is true when all shareholders are paid the same dividend, their relative ownership or interest in the company does not change. If half choose to reinvest in additional shares and half do not, then investors who reinvest increase their interest in the company by making the choice that the dividend imparted to them.”

Note that, regardless of whether you choose to reinvest, your dividend is now taxable. The company has distributed money in such a way that the IRS views your basis in the cash as zero. And what do you have? You have the same percentage ownership, cash dividends, and a near-term tax liability on the WHOLE dividend.

Compare that to a buyback where, GIVEN that you retained your position, you now have a higher stake in the company with no near-term tax liability. You can choose to sell a portion of your share to return to your original percentage ownership, thus effectively manufacturing a dividend. Subsequently, you have the same percentage ownership, cash dividends, and a near-term tax liability on your GAIN ON SALE. The buyback gives you more flexibility because of the tax considerations.

So, you can see how mechanically the two operations are very similar, and how the differences are created by taxes, primarily. If you own an overvalued stock, why? But if you do, then a dividend does not provide any advantage to a buyback. It merely automates the process of maintaining your percentage ownership. And for that privilege, people allow their basis on the sale to go to zero.

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Lawrence Sautter March 28, 2014 at 6:31 am

There may be taxreasons for share buy-backs being preferred. Where there is a double taxaction of dividends, i.e. the company pay tax and then shareholder are also taxed on their dividends, buy-backs may be more efficient. The buy-back may also favour investors if it triggers capital gains tax rather than perhaps higher rates of income tax that a dividend might attract. Wher this double taxation exists there may be a tendency to minimize dividends and keep the cash within the business. This is not a problem provided it is used effectively. With debt attracting tax relief, this may also lead a company to have a preference for debt rather than equity. It may also be that the market is sceptical as to the management’s ability to use the funds effectively in a strategic move such as an acquisition. It may be felt that the return on the money invested, taking into account the risks involved, would be lower than investors could generate in other companies. Accordingly the cash will be distributed to shareholders. Some studies suggest that it is companies that grow the dividend that prove the better long-term investment. Therefore an attractive yield, with a secure and growing dividend, is likely to offer a better total return.

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Shailesh Kumar March 28, 2014 at 3:35 pm

Lawrence, yes for the most part. I believe that the management’s fiduciary duty is to maximize returns to the shareholders. Let the shareholders worry about the taxes since each shareholder’s tax situation is different. Given that majority of the stock is owned as part of tax advantaged retirement plans in US, it will be a little disingenuous for the management to take on shareholders tax planning as one of their roles. To be fair though, this reason is often mentioned.

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