When a company has excess cash that it wants to distribute to shareholders, it has two main options. It can pay out a cash dividend. Or it can use the money to buy back shares, paying the shareholders that way. Given the rise in share buybacks over the past year, is this a viable way for me to build up a passive income?
Different potential options
Share buybacks tend to happen in a couple of different ways. One way is that if I own a stock, I might get a notification of a tender offer. I can opt in to sell some of my shareholding in the firm at an agreed price. So if I own 10 shares in the firm and put forward to sell half, I’ll receive the cash value of the five shares.
A buyback can also happen whereby I’m not directly approached. Rather, the company will simply go to the stock market and purchase a set value of the company shares. Unless I choose to sell my stock, I can’t be forced to sell it.
Clearly, buybacks do have the potential to generate income if I choose to sell with a tender offer. However, it’s not that sustainable as once I’ve sold the stock, I cease to get any further benefit. This differs from a dividend, in that I can keep receiving income from dividends if I hold the stock.
Gaining from the share price
Instead of making income from a buyback, I do stand to gain from share price appreciation. After all, in taking shares off the market, there are less shares in circulation. All things being equal, this should raise the value of the share price.
So let’s say that a company wants to pay out cash to shareholders and buys back a lot of shares over the course of a few years. Even if I don’t sell mine, the increase in the share price should mean the value of my holding increases. To generate income, I can look to trim this profit by selling over time, while keeping my initial amount still invested.
A good example
Let’s consider BP (LSE:BP) as an example. Following the release of the full-year results earlier this month, the firm committed to repurchasing $14bn worth of shares by the end of 2025.
Alongside this, a dividend was also announced. Based on the $0.28 total dividend per share from the past year, the current dividend yield stands at 4.76%.
The share buyback isn’t via a tender offer, so BP will be going to the market in order to buy the stock back. The share price is down 15% over the past year, but based on the results as well as the cash being paid out, I think potential income investors will be interested.
A risk is that with the money leaving the business, BP is in a less stable financial position. Yet given that it generated a profit before tax of $23.7bn, I don’t see this being a big problem.
I’d look to buy BP shares for income via dividends, not future share buybacks. Sure, the repurchasing could help lift the share price. But in my view, buybacks are more of a signal of positivity from a business, rather than an action that should cause me to buy a stock.
