Dividends vs. Stock Buybacks

Companies have several means through which they share their prosperity with shareholders. Dividends are the portion of corporate profits paid out to stockholders in the form of cash. Share buybacks on the other hand represent cash distributed to existing shareholders in exchange for a fraction of the company’s outstanding equity. While both methods have their pros and cons, when used carefully, they could strongly add to the total returns of long-term shareholders.

Share Repurchases have gained popularity among companies because there's a total flexibility with them, whereas dividend payments require a commitment. With repurchases a company could spend billions buying back its stock in one year, and then spend nothing for the next few years. With dividends however a company that cuts, eliminates or suspends its payment would likely enrage shareholders.

Some investors believe that stock buybacks are the most tax efficient way for companies to return cash to shareholders. Currently, the highest tax on qualified dividend income is 15% for the top income tax bracket. When companies earn money, they pay taxes on it. When companies pay dividends, dividends are taxed again at the individual level.

When companies repurchase their own shares, they decrease the number of outstanding stock available, which theoretically increases the stock value. Some investors consider this to be the most tax efficient method of returning cash to shareholders, since there is no tax on repurchasing shares. These investors seem to forget however that the holders of stock who sold to the company end up paying a capital gains tax on their profit. While not all shareholders sell stocks to companies, which are repurchasing their own stock, the ones that do could end up with a higher tax bill at the end of the day, especially if they were long-term buy and hold investors.

One reason for the increased popularity of buybacks is that companies do not wish to commit to a certain dividend level, since their earnings are volatile. Stocks like Exxon Mobil (XOM) didn’t pay a large dividend during the huge run up in oil prices over the past decade, partly because their executives might have believed that once oil prices stabilized, dividends would have had to been cut in order to account for the new reality. It looks like Exxon Mobil managers were correct about using caution in expecting the good times to continue indefinitely. Projections for near term earnings per share are to contract by 50% in 2009 before recovering to only two-thirds of the record earnings numbers from 2008. Check my analysis of Exxon Mobil.

Some analysts believe that companies use share buybacks as a clever way to offset shareholder dilution from exercised stock options from management. With stock repurchases companies fail to reduce share count due to new issuance of stock to redeem employee stock options. Stock buybacks are typically initiated in good times, when stock prices are high and discontinued in bad times, when stock prices are low, Thus, corporations end up purchasing their own stock at inflated prices, which greatly limits the supposed benefits of increasing the ownership percentage of each share owned by stockholders.

General Electric (GE) is a prime example for this. In 2007 the company spend $12.319 billion buying back stock, which reduced the share count from 10394 million to 10218 million, or a decrease of 176 million shares. This comes out to $70/share, whereas the high and low prices of GE stock in 2007 were $42.15 and $34.50 respectively. This sure tells us that the company gave out at least one hundred million shares through option exercises. Facing a liquidity crunch in 2008 the company was forced to sell $12 billion worth of stock at $22.25/share, much lower than the price is had paid for buybacks over the past 4 years. Back in February 2009, the company cut its dividend as well in order to conserve cash.

IBM is another interesting buyback stock to research further. Over the past decade, the worldwide supplier of advanced information processing technology and communication systems and services and program products has managed to decrease the number of shares outstanding from 1.852 billion at the end of 1998 to 1.339 billion by 2008. At the same time revenues have increased by 18.4% from $87.548 billion to $103.63 billion over the past decade. Earnings per share increased by 116.75% from $4.12 to $8.93, mainly due to share buybacks, since net income only rose by 60.4% from $7.692 billion to $12.334 billion in the process. $100 invested in IBM stock at the end of 1998 would now be worth $130.30 with dividends reinvested, and only $117.4 without reinvestment. Dividend payments increased from 0.11/share in 1998, when the yield was a little less than 0.5% to $0.55/share, for a yield of less than 2.1%.

The company has spent $73 billion on share buybacks, which should have been paid out as special dividends instead. This would have increased the total returns for shareholders by rewarding them with a higher dividend payment, the compounding effects of which could have greatly magnified long-term stockholder returns. I am a supporter of the extra cash being paid out as a dividend, since its contribution to the total returns would have been more visible than share buybacks. Check my analysis of International Business Machines (IBM).

Dividends on the other hand are mostly cash in hand that gives the investors options about their further allocation. They could be spent, re-invested in the same or other stocks or could be placed in a savings account. Dividends are somewhat more predictable and reliable sources of income, especially if you are looking for an alternative income stream in retirement. Furthermore, dividends
Dividends have contributed a large portion of total returns to shareholders. They typically account for 40% of average annual total returns each year and are the only form of returns on investment that shareholders achieve during bear markets. The reinvestment of dividends has accounted for majority of S&P 500 total returns as well over the past century.

Companies that regularly pay dividends impose a discipline on managers to treat cash very carefully and thus make better decisions by adopting projects, which would generally improve the bottom line, without sacrificing return on equity.

It would be much easier for an individual who plans on living off their investments to rely solely on dividends that on hoping that share buybacks would lift the value of his or her stocks. Selling your stocks at the midst of a bear market in order to sustain your lifestyle doesn’t make much sense, yet investors keep cheering the supposed “tax efficiency” of stock buybacks.

I typically treat share repurchases the same way as special dividends. Share buybacks are inferior to dividend payments, as they could be canceled or temporary suspended at any moment, without many investors noticing this. Dividend payments on the other hand are visible to shareholders and cutting or eliminating a payment would certainly create negative publicity for the company. I would much rather see special dividends, rather than stock buybacks, which are a clever way to mask the diluting effect of employee option being exercised.

Disclosure: None

Comments

[Lightway:]

Agree with your article completely. Microsoft is another example of a company doing share buybacks, and the stock has gone nowhere over the past decade, when it could have used that money for dividends or growth initiatives.

Microsoft and IBM also just laid off a big chunk of their workforces.

Jun 23 07:10 PM

[najdorf:]

The GE example in the article is right on - surely this company, with huge liabilities matching tons of risky assets, could have seen the need for more reserves or debt repayment rather than continuing buybacks at prices where the return couldn't possibly be that great.

IBM and MSFT are different cases because they don't have GE's debt load or risky assets. Their cash flows are about as stable and predictable as they get outside of utilities, their debt is low-rate and manageable, and their reserves are adequate. There's no good reason they shouldn't repurchase shares. IBM has done a great job generating positive returns since 1998 when many tech companies have destroyed shareholder value with poor acquisitions and strategies. They also have seriously increased the dividend in recent years. MSFT has been somewhat less successful, I think because they haven't found the right way to enter new markets and drop unprofitable businesses (example: MSFT continuing to burn money online while IBM exits a weak laptop business to focus on software). But even still, many many stocks have done worse than MSFT, and the share price has been on a decent run of late. You have to remember that good buybacks increase real returns (you hold a larger share of a profitable company) while share prices reflect lots of speculative factors (people would pay ridiculous multiples of earnings in the late 90s - the bursting of the bubble was due to a shift in this perception rather than MSFT or IBM management errors).

Lightway: Please explain how IBM and MSFT could have grown larger than their current size by reinvesting more cash in their business (remembering that both carry large cash balances even as it is). I would argue that MSFT in particular currently is in too many businesses with lower margins than their home and office software - internet search, gaming, etc. I would rather see the company run as a cash-flow generator that investors can direct to their own investments in independent tech smallcaps than see MSFT make a bunch of overpriced acquisitions or internal growth initiatives that get lost in a huge corporate culture.

Jun 23 10:08 PM

[donzelion:]

There's a "forward/backward looking" element at play with GE, Microsoft, and IBM, and with talent-driven tech stocks in general. GE conducted a bevvy of buybacks at inflated prices, but they were also a dividend stalwart: the dividend rewards retirees and long haulers (e.g., pension funds), and penalizes holders of employee stock options. (Frankly, it's hard to believe Microsoft's initiation of regular dividends was wholly unrelated to the retirement of a certain prominent CEO...)

Both dividends and buybacks can be exploited, so I focus on the frankness of a company's reasoning and look for a mix of both. As DGI notes, transparency matters, dividends are more transparent, and hence, dividends should be overweighted vis-a-vis buybacks (unless a company has a very clear justification otherwise that isn't just boiler plate rehash).

Jun 24 06:13 AM

[Lightway:]

IBM's software big cash cow generator from the earlier part of this decade was from their Websphere java app server, and its development on Linux. IBM poured a boatload of resources into opensource development into Linux, Apache, java, and DB2, and this in turn gave them a huge cash generator.

This came from innovation, and exactly the type of growth I am talking about.

Microsoft used its original operating system to leverage into other areas: the back office, server operating systems, corporate infrastructure, etc, even Xbox. Somewhere along the lines, this movement into new areas fizzled out and the company turned into a utility-like entity with a drive that has been lost, and a return on investment that could have been much better than the mediocre efforts to maintain the status quo.

Cisco is another example of a tech company that knows how to use cash flow to fund future growth. So I don't think size and growth are mutually exclusive factors.


> Lightway: Please explain how IBM and MSFT could have grown larger
> than their current size by reinvesting more cash in their business
> (remembering that both carry large cash balances even as it is).
> I would argue that MSFT in particular currently is in too many businesses
> with lower margins than their home and office software - internet
> search, gaming, etc. I would rather see the company run as a cash-flow
> generator that investors can direct to their own investments in independent
> tech smallcaps than see MSFT make a bunch of overpriced acquisitions
> or internal growth initiatives that get lost in a huge corporate
> culture.

Jun 24 08:42 AM

[David Van K...:]

"You have to remember that good buybacks increase real returns (you hold a larger share of a profitable company) while share prices reflect lots of speculative factors ..."

This statement is self-contradictory. No return is "real" until the money is in your hand. Until then, it's just on paper. A dividend is a real return as soon as you receive it. But a share buyback introduces indirectness between the company's action and any "real" return: The market must re-price the shares to reflect that there are fewer of them (something markets don't always do), and then you must sell the appreciated shares to gain a real return.

It is the necessity to sell the shares that makes the statement self-contradictory: As the commenter said, "...share prices reflect lots of speculative factors...".

Jun 24 11:29 AM

[football frank:]

I have my own buy back formula, I re-invest the dividends, which
makes compounding work for me.
As a long term investor, I'm not really worried about the share
price at the moment. Looking twenty years down the road. Of
course when you buy good companies, that pay a good dividend the
share price will follow sooner or later.
Buybacks tend to waste cash.

Jun 24 10:35 PM