How Companies Create Shareholder Value

Companies return and create shareholder value through dividends, buybacks and earnings growth.

In this post:

1. The dividend yield is calculated as expected dividend for 2009 divided by the annual average price during 2009.
2. Payout is calculated as expected dividend for 2009 divided by expected earnings for 2009.
3. "Payout Med" is the median payout ratio over the years since the year end 31 December 2009
4. "Adj Payout" is the payout after considering buybacks net of dilutive events such as employee grants & share issuance on M&A activity.
5. EPS growth is the annualized growth in EPS using expected earnings for 2009 as the end date and earnings for the year end 31 December 1999 as the start date. The number in brackets are the median level of annual rate of change in EPS; this is a useful indicator during years when the start point or end point are a trough or peak earnings year because the annualized growth rates can be misleading during such times.

Detailed quantitative information can be viewed at The Quant Report.

Several investors have expressed dismay in XOM's low dividend. But the historic data indicates that XOM has the best return of shareholder value policy amongst XOM, BP, COP and CVX.

Dividends are nice because they create shareholder choice. The company pays cash, the shareholder pays tax and spends the rest of it. Dividends carry appeal to investors because they provide liquidity and income and the tax cost associated with a dividend is an acceptable cost.

However, a institutional investors and investors who typically elect the dividend re-investment option, might not like a dividend because the tax cost makes it inefficient compared with earnings growth or share buybacks.

Buybacks are nice because they deliver exactly the same end result as a dividend paid with reinvestment, except that because no tax is paid on the number of shares acquired is higher. Thus this option carries appeal to a significant number of investors.

The problem with buybacks is that most buybacks occur during periods when shares trade at a premium to fair or intrinsic value; if a buyback program was, like a dividend, designed to return shareholder value in a consistent and recurring fashion, it would work very well. The alternative would be to have a buyback program built on a market timing model where shares are only bought back when they are undervalued - very easy to say, but very difficult to implement since most companies really do not have in-house expertise to either time markets or determine fair or intrinsic value; investment is not their business, running the company is.

And then there is growth. When a company can be trusted to use the surplus money better than the investor, reinvestment in growth is the best option for growth generates future capital gains which delivers shareholder value. The problem is that in the long term, very few companies can deliver growth at levels which justify retention of surplus capital; too much will be paid on M&A activity, overconfidence will cause overspends on organic growth, competition will eat away benefits of growth. In the early life of a company this option makes best sense; but as it matures a mix of methods to return shareholder value is worth considering.

A company needs to select the best method of returning value to its shareholders after considering the needs of different types of shareholders. Some succeed, as I believe XOM has; some like DELL do not. DELL does not pay a dividend; their share is thus unattractive to income investors; without investor interest from a significant investor group, the share price is severely punished during periods of distress. DELL's buyback program has not been the smartest; it lacks consistency and shares are not purchased when valuation is deeply distressed. And growth is something they delivered beautifully in their early years, but in since 1999, their annualized growth has been a spectacular 0.29%.

Now I have long positions in Dell for many reasons, including because their median level of annual rate of change in EPS is in excess of 20%; I believe the management can turn it around compared with where it is. I am investing on the basis that value will be delivered through growth ultimately; it is a risk a long term investor is willing to take notwithstanding the lack of price stability caused by no dividend and a poorly executed buyback program. And good company need not be a financially smart company!

Personally, I like shareholder value returned via a mix of all three methods. Sometimes I will mix it up and use a higher dividend yield on one stock together with another stock, which in my view might deliver better earnings growth through a turnaround.

Disclosure: Long BP, DELL.

Comments

[Gassy:]

XOM will stick to its belief of increasing dividend for many many years. When it believes it is making super-normal returns it buys back instead of a special div. Both having the same impact. To make life more complicated it may be better to look at debt adjusted cash flow per share growth vs just eps. thanks for your articles.

Oct 12 12:32 PM

[David Van K...:]

"Return of shareholder value" is a very fuzzy phrase. Let's get specific.

Dividends: This is a direct return. It is always positive. Dividends are lightly taxed. For the best-chosen dividend companies, this return is highly reliable, and it will show steady increase in absolute dollars over the years, simulataneously showing commensurate increases in "yield on cost" over the years. Returns can be accelerated by re-investing the dividends, or the money can be used as current income.

Share buybacks: Theoretically, these work as described. But they are usually an inefficient use of company money for the reason described: Companies tend to "buy high." The return can only be realized through the sale of shares, and then profits are taxed. Returns are not reliable, as share buyback programs tend to be individual events, not annual practice tantamount to corporate policy as are most dividend programs. Many share buyback programs are never completed; they are cut off with little publicity.

Earnings increases: Shareholders benefit from earnings increases only through an indirect mechanism: the market. The market must recognize the increases and value them fairly (if not favorably). The return to the shareholder only takes place through selling the shares, whose profit is taxed.

I disagree with those who believe that dividends and share buybacks are equivalent from the investor's point of view. Dividends are much better.

Oct 12 02:03 PM

[Dividend Gr...:]

I agree that dividends are great, although to have a rising and sustainbale stream of dividends you need to have a sound business model that produces rising earnings.

As for buybacks, I treat them just like special dividends - it's nice to have them but don't rely too much on them..

Oct 12 03:44 PM