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Apple has recently announced its largest-ever stock buyback of $110 billion. This news is significant as it sheds light on why US stocks are at an all-time high.But what exactly is a stock buyback and how does it differ from a dividend?
Stock Buyback vs Dividends
In simple terms, a stock represents a share of ownership in a company. You would assume that when a company is profitable, it usually pays dividends to its shareholders. However, in most cases, the earnings go to two other places:
- Retained earnings: Earnings are reinvested back into the company’s operations to generate higher profits. This decision is made when the company has opportunities to earn higher returns than their cost of financing. By retaining these earnings, the value of the company naturally increases.
- Share buybacks: Companies choose to buy back their own stocks from the market. This creates large buying pressure on the stock as the number of shares outstanding is reduced, leading to an increase in its price. This is essentially an indirect dividend for the shareholders—why pay a dividend when you can simply buy back stocks from the market? By doing so, there becomes large buying pressure on the stock as the amount of shares available to purchase is reduced. This process ends up driving up the price. Think of it as an indirect dividend.
So why would a company choose to do a share buyback when it could simply pay a dividend?
Tax
When taxable investors receive dividends, they pay a tax on income. Many investors don't require an income and would rather delay their tax implications to the future. A share buyback, on the other hand, simply raises the intrinsic value of the share price to where it would have been if they had paid a dividend, without the tax implication.
Therefore, if the investor would like to take income, they can simply sell the stock and realize some gains, which would be applicable to a realized gains tax.
In summary, for more than thirty years now, companies have preferred to do share buybacks rather than paying dividends for investor tax efficiency, and that matters a lot for us investors.
So, how is this related to stocks being at all-time highs?
Imagine you own a 20-story building that is fully rented out. Now imagine you have the choice of banking the rental income and paying taxes, or taking the rental income and building an additional 1 floor every year. Many investors who do not need the income would simply keep building floors. In 10 years' time, the building you own is now a 30-story building and news headlines are all bold and saying beware because the value of the building is at an all-time high! The news here is deceiving people to think that your building's value is overvalued because it's priced at all-time highs, while not mentioning that your building is worth 50% more because of retained earnings.
Stock buybacks work in the exact same way. Imagine this building was owned by 20 investors and was worth 20 million USD. That means each investor’s shareholder value was 1 million USD due to owning the equivalent of 2 floors. Now again, let's imagine instead of paying out the rental income to the 20 investors, each year, 19 investors choose to use the rental income to buy out the value of 1 investor to sell out. After 10 years, there are only 10 investors left, and the value of the building is unchanged at 20 million USD (2 million USD for each investor). The news goes wild and says that the share price is at all-time highs! However, they do not mention that the value of the building is unchanged.
Summary: Stocks are designed to be at all-time highs
For the above reason, even if we disregard earnings growth and inflation, stocks are by design meant to naturally be at all-time highs due to retained earnings and share buybacks. Companies have no reason to exist other than to make profits, and that’s exactly what they will keep doing. As long as companies are selling goods and services, you can safely assume that stocks will normally be at all-time highs.
Here are some charts depicting the same with a data-driven approach:
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