Should Companies Pay Down Debt or Buy Back Shares?

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This is often a much talked about subject with dividend stocks. Should a dividend paying company buy back shares or pay down debt?  After investing in R&D, increased their dividend payment, and all of the other business activities, what should they use their extra money on? While either extreme of only doing one can be bad, there is advantages to both. Some companies even take on more debt to buy back shares.

Extremes: One extreme is to buy back all of the shares. Then they become a private company and I cannot invest in them. There are lots of them, but do not help us here.

Then there is no debt. If the company has no debt, then the shareholders actual have assets in the company. Usually, the bond holders have access to all of the assets in bankruptcy. However, having no debt could cause a company to miss out on an opportunity that could help a company to grow.

Cash Flow: With cash flow, the bigger yield should be bought back. If your dividend yield is 3% and your bond interest rate is 6%, then paying down debt should be done first. Cash flow improvement will be twice as good with debt being paid down in this example.  Or if the numbers are reversed, then the reverse will help more.


Dividend Increase: This will be the same as above. Whichever one has the higher interest rate, then that should be bought to increase future dividends faster.

Debt Level: Buying back stock does nothing to reduce debt level. Paying down debt pays down debt.  (I will hold a press conference for this idea.)

Earnings: When a company pays down debt, interest expenses go down in the earnings statement. Dividend payments are not on the earnings statement.  So paying down debt helps earnings more.

Enterprise Value: Enterprise value includes stock value (market cap), cash, and debt in general. Paying down debt will also decrease cash, keeping this value the same. Buying back stock will likely decrease this number, unless the stock price goes up with the buy back.  That is often assumed, but does not always happen, because buybacks can be poorly timed.

Business Downturn: If business struggles sometime in the future, regardless of the reason, having less debt is better. Shareholders cannot cause a bankruptcy over dividends, but bondholders can over payments. The less bond holders you have, the better.

Timing: Share buyback can be very good when timed well.  If a company’s stock price falls by 50% for any reason, then a stock buyback can make a lot of sense.  When the price is down 50%, twice as much stock can be bought for the same amount.

Share Price: Share price is often determined largely by the PE (Share Price / Earnings). If a company buys back 50% of shares, then the stock price can increase by 100%, or double. That is good. If they use that same amount to buy back debt, then the stock might go up 60%, making some assumptions about current PE and interest rates. Looking at the near term or next quarter results, buybacks can be better for share price. So when times are good, a lot of people like stock buy backs. However, when times get tough, previous stock buybacks will not help much, but having less debt helps a lot. And if you are one of the remaining companies still doing good, you can buy back shares then for a cheaper amount.

Overall: There are a lot of different types of stocks. Knowing why you are investing makes this important. Are you trading the next quarters or year’s results, then you may want the buybacks? However, we are investing in the long-term. In the long-term, I would rather a company to pay down debt than buy back shares. Paying down debt does not have as much immediate share price improvement as share buybacks. However, considering the whole pictures, and I am hopefully investing for decades, I want my companies to buy back debt. However, when the stock market goes on sale, like we were in for the last few months, buying back stocks can be a better choice.  So while either extreme can be bad, timing can be very important.

 

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One thought on “Should Companies Pay Down Debt or Buy Back Shares?

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