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We have seen an increase in both share buybacks and dividends in recent years, with the economic situation in the country improving over the past few years, and as companies have increasingly large cash hoards. With the cash hoard, companies have two main methods to thank shareholders: Share Buybacks and Dividends. But which of the two is more beneficial for shareholders, and more efficient?

Share Buybacks

Share buybacks refers to the program which a company uses to buy back its own shares from the market, effectively reducing the number of outstanding shares. The company, through this action, could be sending a message that its company's shares are worth buying at the current price, or even that its company is the best choice for investors.

Benefits Of Share Buybacks

One benefit of share buybacks is that they tend to make valuations and earnings metrics look quite a bit better. For example, share buybacks can cause an increase in both a company's EPS and its share price, as shown in the case of DirecTV (DTV). DirecTV cut down over a quarter of shares outstanding in three years. The table below shows more detailed figures.

YearShares Outstanding (Millions)EPSEarnings ($)EOY Share Price
20116913.472.61B42.76
20125874.582.95B50.16
2013513 (est.)5.95 (est.)3.05B (est.)63.99 (price now)
Growth Per Annum-9.4%19.7%5.3%14.4%

This example illustrates the power of share buybacks perfectly. Although earnings are expected to go up around 5% per annum over the three years, EPS was actually expected to increase almost 20% per annum from 2011 to 2013. This lowered DirecTV's valuation metrics substantially, giving a boost to the demand for the company's shares. This caused share prices to also increase accordingly, appreciating 14.4% per annum so far (We're still around halfway through 2013).

Besides this, as opposed to dividends, share buybacks defer investors from taxes, and at the same time gives investors the benefit of getting an increase in share price, which arguably produces the same capital-growing effect as dividends.

Pitfalls Of Share Buybacks

There are also quite a few limitations of share buybacks. Firstly, a company usually has excess cash during times which see great economic conditions and fast growth, but, it is usually also at these times that the company's shares reach sky-high levels, or even in some cases, their peak. When the shares decline, on the other hand, during a recession, many companies will be cash-strapped, and share repurchase plans will likely be halted. Although this is the case, it is exactly at these times when the company's shares are at the lowest.

For example, AT&T (T) repurchased its shares until the recession hit, when it halted its stock repurchasing plan, as shown through the figures below.

YearShares OutstandingEOY Share Price ($)
20066.24B35.75
20076.04B41.56
20085.89B28.50
20095.90B28.03
20105.91B29.38
20115.93B30.24
20125.58B33.71

But as seen in the table above, AT&T was actually buying back shares at the sky-high price in the $40s right before the recession, and actually did not buy back any shares when share prices hit a low in the $20s during the 2008-2009 recession. Another example is the fact that S&P500 components bought back more than $500 Billion in shares in 2007, when prospects were bright but also as prices were sky-high. This clearly shows one of the limitations of share buybacks- companies usually repurchase more shares at highs, and lose money as share prices fall.

Secondly, even though a company approves a share repurchase plan, it may not fully carry it out. An announcement of a share repurchase plan might run along these lines:

Our Board has approved a share repurchase plan scheduled to run through the end of 2013 that authorizes us to buy back $X million of XXX common stock.

Although a company has approved a share repurchase plan, it might not be carried out in the end due to all sorts of troubles: perhaps a delay in a project, or earnings which are not up to standards. Many are tricked into believing that whatever is announced is carried out. It is definitely not! In fact, quite a large chunk of announced buybacks are not carried out fully.

This commences what I have to say about share buybacks, let us move on into dividends.

Dividends

Most of us should be quite clear about dividends, so I will not elaborate too much on it. It is simply a distribution of a portion of its earnings to shareholders to keep. Through this action, companies are thanking shareholders for investing their hard-earned money into the stock. Dividends can also be seen as an additional reward for investors on top of returns.

Benefits Of Dividends

Firstly, a shareholder is able to receive something more tangible, that can be used for many other purposes, no matter if it is reinvesting into the same company, buying shares in other companies or accumulating "powder." Many long-term dividend growth investors (including myself) also favor dividends to be reinvested through a DRIP plan. This can compound returns over time.

Secondly, dividends also provide shareholders with an extra margin of safety. Besides this, it has been proven that stocks paying dividends historically outperform both the S&P 500 and the companies that do not pay dividends, as shown in the chart below.

(click to enlarge)

Courtesy of ridgeworth.com

As shown in the above chart, which covers a span of 40 years, from March 1973 to March 2013:

The brown line refers to the general performance of stocks, which do not pay a dividend, and only returned 187% over the past 40 years - which is truly a very disappointing return for 40 years.

The black line refers to the performance of stocks in the S&P 500, which returned an impressive 1,877% over the past 40 years.

The next yellow line refers to the general performance of stocks that pay dividends, which returned an even more impressive 3,557% over the past 40 years.

Lastly, many studies have proven dividend-paying stocks to be less volatile than the general market, especially in high-volatility environments like recessions. This is mainly due to the fact that these consistent dividend-payers are typically companies like Johnson and Johnson (JNJ), Procter & Gamble (PG) and Colgate-Palmolive (CL). These companies have sound businesses and possess strong records of generating steadily-increasing, reliable earnings and also consistently growing cash flow to be able to pay a dividend.

Pitfalls Of Dividends

Although this is the case, there are also some pitfalls of dividends. The first is the opportunity cost a company accepts when paying dividends. The company could have used these funds to invest in its underlying business, to create further growth. Warren Buffett is one great supporter of this kind of thinking, never paying dividends to shareholders of Berkshire Hathaway (BRK.A)(BRK.B), instead investing funds into the business. The result: A book value growth of over 460,000% over the past 45 years. Therefore, there is this significant opportunity cost that companies take up when paying shareholders dividends.

Secondly, shareholders may not receive their dividends in full, mainly due to taxes imposed by the U.S. government. The situation is made even worse for dividend investors overseas (like me), who are subjected to a heavy 30% withholding tax. Therefore, in this sense, dividends may not be such an efficient way to return to shareholders.

Conclusion: Dividends vs. Share Buybacks

Here is a table to sum up the benefits and limitations of both dividends and share buybacks.

Share Buybacks
BenefitsPitfalls
1.Better looking valuation & earnings metricsCompanies usually repurchase when shares are most expensive
2.Defers investors from income taxesApproval of a plan does not mean carrying it out
Dividends
BenefitsPitfalls
1.Something more tangible, many uses of the cashFewer funds to invest in company growth
2.Dividend-paying stocks historically outperform indexes and non-dividend paying stocksSubjects investors to taxes
3.Generally less volatile

So, after all, which of the two is more beneficial to shareholders? The answer is actually "It all depends." I cannot decide for you; you will have to decide for yourself, as it really depends on every individual's situation. Factors like investment horizon, financial situation and the ability to tolerate risks come into play here.

But personally, I prefer dividends more. I like the fact that dividends are cold hard cash that is passed on to the shareholders, and that we can choose when we want to put that cash to use. I am also a big fan of the idea of compounding, with my long time horizon. But I feel that it must also be done in moderation. Paying shareholders just the right amount would suffice. I do not believe in spending so much in such payments that it would threaten a company's future growth.

Finally, do not hesitate to enter some of your opinions in the comments column below - I would love to see some of your opinions on the topic.

Source: Share Buybacks Vs. Dividends: Which Is More Beneficial?