How Stock Buybacks and Dividends Can Lower Your Investment Basis

When investing, protecting your capital should be your highest priority. The best way to do this is by continuously lowering your investment basis—the average price you paid per share. A lower basis not only protects your capital but also enhances your returns. This article explains two powerful strategies—stock buybacks and dividends—to reduce your basis effectively.

Why Lowering Your Basis Matters

The investment basis refers to the original price paid for shares. Reducing your basis lowers the risk of losing money and increases your potential gains. The lower your investment basis, the higher your profit when selling shares at market value.

Five Proven Tactics to Lower Your Basis:

1. Invest only in wonderful businesses on sale.

2. Stockpile cash for opportunities.

3. Utilize stock buybacks.

4. Collect dividends.

5. Leverage derivatives.

In this article, we'll delve deeper into tactics three and four—stock buybacks and dividends—examining how they help investors lower their basis effectively.

Understanding Stock Buybacks

What is a Stock Buyback?

A stock buyback occurs when a company repurchases its shares from the open market using its excess cash. Essentially, the company is reinvesting its surplus equity by returning it directly to shareholders through increased share value.

How Buybacks Lower Your Basis

Done correctly, stock buybacks can significantly reduce your investment basis. Imagine you and nine others each own a slice of pizza worth $1 per slice. Due to temporary market conditions, each slice's price drops to $0.20. If the CEO wisely uses $1.80 of the company’s cash to repurchase nine slices, you become the sole owner of the pizza. Your original slice (investment) was $1, but now you control the entire pizza, worth $10 minus the $1.80 spent, netting you $8.20 in value. Your effective basis per slice dramatically decreases.

Similarly, when a company repurchases its shares at prices below their intrinsic value, the value per share increases for remaining shareholders, thus effectively lowering their basis. Conversely, poor management decisions—like buybacks at inflated prices—can diminish shareholder value.

Evaluating Buyback Effectiveness

A buyback’s effectiveness can be measured by observing its impact on earnings per share (EPS) and return on equity (ROE). Buybacks executed at undervalued prices enhance EPS and shareholder value, while overpriced buybacks reduce it. Wise investors track these metrics to determine whether buybacks are genuinely beneficial.

Leveraging Dividends to Lower Your Basis

The Power of Dividends

Dividends are cash payments made directly to shareholders, representing distributions of excess company profits. Each dividend received reduces your investment basis, as it's effectively returning a portion of your initial investment.

For example, if you originally invested $50 per share and receive $5 in dividends, your new effective basis becomes $45. Over time, consistent and growing dividends can substantially reduce your original investment basis.

Identifying Reliable Dividend-Paying Companies

Not all dividend-paying companies are equally beneficial. Exceptional businesses consistently generate excess cash, funding dividends without jeopardizing their financial health. In contrast, poorly managed companies might borrow funds to sustain dividends artificially, which is financially unsustainable and a significant red flag.

To evaluate dividend sustainability, examine two financial metrics:

• Operating Cash Flow: Healthy businesses have consistently increasing operating cash flows.

• Free Cash Flow: Calculate free cash flow by subtracting capital expenditures from operating cash flow. If free cash flow consistently exceeds dividends, the company likely has sustainable dividend payments.

Long-term Benefits of Dividend Growth

Consistent dividend growth significantly amplifies returns. Consider Coca-Cola: historically, Coca-Cola has grown dividends annually by approximately 8-10%. Such companies continually enhance shareholder value and steadily reduce your investment basis.

Over ten years, accumulated dividends can drastically reduce your basis, enhancing your annual return. For instance, dividends accumulated over a decade might bring your effective basis close to zero, dramatically boosting your return on the original investment when compared to market prices.

Buybacks vs. Dividends: When to Prefer Each

Companies typically choose between buybacks and dividends based on stock valuations:

• Buybacks: Optimal when stock prices are undervalued. Repurchasing shares at low valuations effectively redistributes equity, benefiting long-term shareholders.

• Dividends: Ideal when stock prices are high, making buybacks inefficient. Paying dividends in these scenarios returns excess cash directly, benefiting shareholders without risking capital through overpriced buybacks.

Final Thoughts

Using stock buybacks and dividends strategically can significantly reduce your investment basis, protecting your capital and increasing potential returns. The key lies in choosing wonderful companies and carefully analyzing buybacks and dividends' appropriateness.

Now, equipped with this knowledge, you can invest wisely, continually reducing your basis and securing robust long-term returns.