One of the most obvious ways of earning passive income is by owning shares in companies that distribute their earnings in the form of dividends. But there is another way.
Berkshire Hathaway CEO Warren Buffett prefers share buybacks as a way of distributing cash to shareholders. And if I were trying to generate passive income, I’d be looking for the same.
Share buybacks
Repurchasing shares is a way for a company to use its excess cash to provide value to its owners. If it’s done correctly, it can be very effective.
Suppose that I own 10% of a business. If the company decides to use its cash to repurchase 5% of its outstanding shares, my ownership of the company increases to 10.5%.
That means that I can sell 5% of my investment while keeping my ownership in the business at its previous level. The cash that I generate like this constitutes passive income.
Warren Buffett prefers this approach to dividends. This is evident by the fact that Berkshire buys back shares instead of paying a dividend and the stocks that it owns in its portfolio.
Warren Buffett stocks
Three of Berkshire Hathaway’s largest investments are Apple, Bank of America, and American Express. Each of these demonstrates Buffett’s approach to passive income.
All three stocks pay dividends to shareholders. But none has a particularly significant dividend yield.
At today’s prices, Apple’s dividend yield is 0.65%, American Express pays 1.38%, and Bank of America has a 2.39% dividend. With inflation at 11%, none of these is that exciting.
Each of these companies, however, spends far more on share buybacks than they do on dividends. And that’s where the real passive income comes from with these investments.
Last year, Apple spent $89.4bn on buybacks, compared to $14.8bn on dividends. Bank of America used $11.6bn vs $8.4bn and American Express spent $6bn vs $1.5bn.
Passive income
Over time, these companies have been extremely valuable for shareholders. By reducing the outstanding share count, owners have been able to generate significant passive income.
Apple has reduced its share count by an average of 4.9% per year for the last five years. That return significantly eclipses the 0.65% dividend.
Bank of America has reduced its share count from 10.7bn five years ago to 8.2bn today. That’s an average of 5.3% of its outstanding shares repurchased each year.
Lastly, American Express has repurchased 3.2% of its shares per year on average. This has allowed shareholders to earn passive income by selling 3.2% of their stake each year.
Investing
Before buying any stocks, it’s important for me to have enough in savings to take care of emergencies. But once I have that, I’d start looking to build passive income streams.
Dividends are one way of doing this. But I’d follow Warren Buffett and look to buy shares in companies that repurchase significant amounts of their outstanding shares.
This would allow me to generate passive income by selling part of my investment without diluting my stake in the company. Over time, this could earn a significant return for me.
