Stock Buybacks vs. Dividends
Same or Different?
Many investors dislike buybacks, as «it’s better to receive real money, like with dividend payouts». However, not everyone realizes that if you’re invested in a classic capitalization-weighted index fund, its managers will automatically, in a sense, convert any buyback into an equivalent cash inflow to the portfolio (almost like receiving a dividend). In this article, I’ll explain how this happens and what unexpected (and not always pleasing for passive investors) consequences this process entails.
Why dividends and buybacks should be equivalent
We will start with the easy part. Here’s the deal: suppose a company has accumulated cash on its balance sheet that it doesn’t have particularly great ideas for — how to invest it in business growth with a targeted return on capital. Such «excess» money would be better returned to shareholders (let them decide what to do with it next).
This can be done by paying dividends to all shareholders (the classic method), or alternatively, the company can announce a buyback and spend the same amount of money repurchasing its shares from the market (a more modern approach, especially popular among American firms these days). For some reason, among the broader retail investor crowd, buybacks are often seen as the ultimate evil on Earth; but honestly, there aren’t any significant conceptual differences between these two ways of returning cash to investors.
More precisely, there are differences in tax efficiency, but they tend to favor buybacks. The thing is, under the tax rules of most countries, investors can’t avoid income tax on dividend payments — so announcing dividends means extra costs for all shareholders. Buybacks, however, don’t have this drawback: if you don’t want to receive cash, just don’t sell your shares, and that’s it!
An important point here is that neither paying dividends nor conducting a buyback for the same amount creates additional returns for shareholders — it’s merely a redistribution of money from inside the company to the external world. When dividends are paid, the company’s stock price should drop to reflect the reduction in assets that shareholders have a claim to.
With a buyback, however, the stock price in an efficient market, in theory, shouldn’t change. On one hand, each remaining shareholder’s ownership stake in the company increases (since the shares repurchased during the buyback, held on the company’s balance sheet, effectively «don’t count» anymore when dividing up the business’s benefits — they can be thought of as «canceled out»).
But on the other hand, an asset in the form of cash has left the company — so the «total size of the pie» to be divided among investors has also shrunk. These two opposing effects should, in principle, balance each other out: if the share repurchase was done at market prices, the money spent on it should, by definition, match the current market value of the repurchased business stakes.
So, we come back to the idea that both methods of paying out money to shareholders are equivalent. Neither dividends or buybacks make shareholders richer or poorer at the moment. Similarly, the company’s total market capitalization decreases in both cases — because a certain amount of money leaves the business «to the outside».
How index funds turn buybacks into dividends
When I talk about the equivalence of share buybacks to dividends, the discussions among investors sometimes get very heated. Good old common sense confidently tells investors that this is clearly some cynical scam: YOUR money from the company’s accounts is taken and paid not to you, but to some RANDOM dudes. If this isn’t outright robbery — it’s definitely something close to it in the conceptual realm!
For some reason, the argument that any buyback can be manually converted into an equivalent dividend doesn’t seem convincing to people. All you need to do is sell a portion of your shares in such a volume that your ownership stake in the company returns to the pre-buyback level — then you’ll have some cash in hand (=dividend), and from the perspective of your ownership rights in the business, nothing changes.
Now, here’s an unexpected fact: if you’re invested in a classic capitalization-weighted stock index fund, when companies in the index conduct buybacks — the fund managers actually transform them into «dividend» cash in roughly the same way. Don’t believe it? Let’s break it down!
As we just discussed in the previous section, both dividends and buybacks reduce the company’s total market capitalization, which makes sense — in both processes, assets (money) flow from inside the company to the outside (into investors’ pockets). With fewer assets inside the company, its overall capitalization should decrease.
Dividends reduce a company’s capitalization through a drop in the stock price (we’re talking about the so-called «dividend gap» — the dip in quotes at the moment of dividend payment). This doesn’t trigger any rebalancing on the part of the index fund: the company’s share of the total stock market capitalization and its share in the index fund’s portfolio decrease simultaneously (due to the lower stock price).
But with a buyback, the stock price, all else being equal, remains the same, and the company’s market capitalization decreases due to a reduction in the total number of shares outstanding (specifically because of the repurchased shares). And here’s where the discrepancy arises! In the overall stock market, the company’s share shrinks along with its capitalization, but in the fund’s portfolio, that share remains unchanged (since neither the number of shares in the portfolio nor their price changes on their own). This means that to eliminate this discrepancy with the market, the index fund will have to sell the «excess» shares of the company that conducted the buyback at the next rebalancing (which typically happens quarterly).
So, dear passive investors, if you intuitively despise buybacks with all your heart and dream of milking only dividend-paying cash cows — the managers of index funds are specially performing a buyback-to-dividend transformation for you automatically! However, the cash generated in this process is then immediately used to buy more shares of all the other companies in the index — but that’s a story for another time…
How buybacks can lead to inefficiencies in index funds
From the previous sections, we’ve established that for an investor, share buybacks and dividends are roughly the same thing (except buybacks come with lower taxes).
The logic I described relied on the assumption that a buyback is conducted at market price, and that this market price is a reasonable approximation of the fair value of the shares (at least from the perspective of the collective, unconscious opinion of investors). In this case, an equivalent exchange occurs between the amount of cash and the repurchased ownership stakes in the business, and the stock price on an efficient market, all else being equal, shouldn’t change.
But if we deviate from these conditions, the situation changes. A buyback at a discounted price creates value «out of thin air» for all remaining shareholders, and conversely, a buyback at an inflated price actively harms those shareholders. This is intuitively clear from common sense; but in practice, it’s not so easy to reliably capitalize on such situations. For example, if you’re firmly convinced that the current market price of a stock is grossly overvalued — then, regardless of any buyback, the automatic question arises: «Why the heck are you still holding it in your portfolio?»
On the other hand, if we assume that the market price of a stock occasionally deviates from its fair value — it’s probably easiest for the company’s management, as insiders, to notice this, since they should know all the inner workings of the business in detail. Accordingly, competent leadership should be more eager to conduct buybacks when the stock price appears relatively undervalued to them and hold back when the stock is overpriced (in which case, it might even make sense to do the opposite — issue new shares and sell them into the market at «juicy» prices).
The fact that these processes do happen in real life can be easily illustrated with the example of additional share issuance. Over the past five years, we’ve witnessed the rise of so-called «meme stocks» — securities that trade at prices far above any reasonable «fundamental valuations», even if you plug wildly unrealistic assumptions into those valuations.
What do you think the management of these companies does at the peak of their stocks’ «meme-ness»? Of course, they crank up the printing press for new shares to flood the market while it’s still willing to buy them at such insane prices! Sometimes it borders on outright comedy: in 2023, the meme company Bed Bath & Beyond increased the number of its shares outstanding by nearly seven times (!) in just a couple of months, right before filing for bankruptcy (naturally, during this entire issuance spree, the management was well aware of where things were headed).
Now we are coming closer to the interesting part. In January 2025 an interesting study came out, where the authors tried to test the hypothesis that «company management tends to conduct buybacks of undervalued stocks and issue additional shares of overvalued ones» on a more systematic level.
Their logic was as follows: as we already know, index funds, during rebalancing, are forced to sell shares during buybacks and buy additional shares during new issuances — meaning, under our hypothesis, they end up selling undervalued stocks and buying overvalued ones. Indexes typically rebalance quarterly; so, what if we delay the rebalancing and do it once a year — to avoid falling into this trap of «bad timing for buys/sells»?
And they actually found that such a «lazy rebalancing index» outperforms the market (i.e., the classic index) by about 0.25% annually based on data from the last 40 years. It’s not much, but it’s not negligible either! Moreover, the result appears relatively robust across different periods: the worst decade in the sample lagged by just -0.02%, while the best decade outperformed the market by 0.51%.
Pretty curious and unexpected conclusion from this whole discussion about buybacks, don’t you think? We will talk about how to use this situation to an investor’s advantage in a future post.