Dividend Taxes Part II: Options, Dilution, and Share Buyback Primer

For those familiar with dilution and share buybacks, much of this post will be old news (but do read the last paragraph), but I want to make sure that the readers understand the lingo before I start tossing it out.

Earlier, I mentioned that there are a few things companies can do with their profits. They can save them as cash, they can reinvest them (e.g., infrastructure or acquisitions), or they can give the money to the owners of the firm, shareholders.

There are actually two ways that firms can give money back to shareholders, the most obvious is to pay dividends in the way described in this post. The second way they can give money to shareholders is for the firm to buy back outstanding shares of the firm. A share buyback is just dilution working in reverse.

Dilution occurs when a corporation gives out options that are then exercised. An option gives the option-holders (usually employees) the right to buy shares in the company at some future time at a fixed price. Generally, when the market price rises above the option price, holders of options can realize a profit by exercising those options. Specifically, the profit is (Market Price – Option Price)*#Options. That’s great for option holders, but not so great for the other shareholders, because now their shares become a little bit less valuable. Go back to the example from my earlier post:

If there are 20 million shares of AB Tech outstanding, then that $4m has to be split $20 million ways, meaning each share represents the right to $4,000,000/20,000,000=$.20. AB Tech will pay this out as a dividend of 20 cents per share. If you own 10,000 shares of AB Tech then you get a check for $2,000.

If AB Tech option-holders exercise 4 million options prior to the dividend payment, the same $4m has to be split 24 million ways. This reduces the per-share payout to $4m/24m=$.167, a dividend of 16.7 cents per share. The shareholder who holds 10,000 shares now only gets $1667, not $2000, in dividend payments because his stake was diluted. To prevent dilution, companies often buyback outstanding shares, to keep the total number of shares outstanding roughly constant. Slate’s Daniel Gross is pretty good on this, here’s the relevant quote:

”Intel spends about $4 billion each year on its own shares, while it pays out just $530 million a year in dividends. Dell last fiscal year spent $3 billion on stock buybacks and paid no dividend.”

A final point on dilution. Suppose there were no options exercised, but AB Tech buys back 4 million shares. Then the same $4m gets split 16m ways, a dividend of 25 cents per share. This would increase the 10,000 share-holder’s payment from $2000 to $2500. Because each share is worth more when there are less of them, their price will go up. Shareholders can make a profit by selling those stocks at the higher price. So when AB Tech buys back outstanding shares, it is putting money into shareholders’ pockets. So at the end of the day, share buybacks work much like dividend payments: they take profits from the firm and give them to shareholders. Another way to think of buybacks is that they are dilution in reverse.

So how does a firm decide whether to put profits in shareholders’ pockets, and if so, whether to do it via share buybacks or dividend payments? (And why should we care?). A large part of the equation is tax treatment. Short term capital gains (gains realized from the price of the share increasing) are taxed at 20%. Dividends are taxed as personal income, at rate between 0 and 36%. Depending on the income-profile of shareholders and the extent to which their holdings are in retirement accounts, buybacks may impose less of a tax burden than dividends.

This is getting us close to the important point about dividend taxes: they do discourage firms from distributing profits to shareholders. And, as it turns out, when firms don’t distribute profits to shareholders they quite often do very silly things with the money. When this happens, it’s bad for the firm, bad for the shareholders, bad for the employees of the firm, bad for the stock market, and bad for the economy. More to come.