In today's low-yield environment, investors prefer dividend stocks. The valuations of most dividend stocks are reasonable, but there are few opportunities that offer really attractive values. Conversely, companies buying back shares don't get the same attention and valuation premium.
But it should. Share buybacks can create incredible value. Let me show you how:
When a company implements a share buyback, a few things happen. First, the buyback reduces the number of shares outstanding. Second, earnings get divided among a smaller number of shares. In turn, earnings per share grow, which often sends the share price higher.
Stock buybacks also have an added benefit of being a tax-free way to return cash to shareholders. That's because -- unlike dividends -- share buybacks aren't taxed as shareholder distributions. Now, stock buybacks are nothing new. Recently, S&P 500 companies bought back large amounts of stock. In the last 12 months buybacks totaled $400 billion. That means they're spending 70% of their cash flow on stock buybacks.
The criticism of most share buyback programs is that executives initiate them at the wrong time. In good times, when companies are flush with cash, executives buy their stock even when the valuation is at a premium. And buying an overvalued stock is always a very poor use of cash flow. That's why valuation is crucial. For investors, the recipe for profits is to own companies conducting big share buybacks that also trade at an inexpensive valuation and have decent growth prospects.
Research from BMO Capital Markets indicates that the 100 companies with the largest stock buybacks beat the market. Their total annual return of 14.2% beats the benchmark by 50%. And the report found that reasonably priced companies doing buybacks performed even better -- returning 17.9% annually.
Consider DirecTV (NASDAQ:DTV). The satellite television company bought back 57% of its shares since 2006. That helped fuel earnings growth, and sent the stock from $15 in 2006 to $58 today -- a 293% increase. And DirecTV continues to buy back its shares. The company is authorized to buy back $4 billion of stock. Shares trade at 12 times trailing earnings. Compare this to the trailing P/E of 19 for the S&P 500, and it's clear that DirecTV executives are buying back a cheap stock.
DirecTV isn't the only company with a big share buyback program and an inexpensive stock. Apple (NASDAQ:AAPL) is buying back $60 billion of stock and trades at 12 times earnings. Or consider Kohl's (NYSE:KSS) and Northrop Grumman (NYSE:NOC) -- both bought back 10% of their shares last year, and also trade at just 12 times earnings.
The good news is that investors don't usually need to choose dividends or share buybacks. That's because most companies with large share buybacks also pay a dividend. My advice -- don't discount the power of the share buyback when evaluating an investment. In fact, the aggressive buyback of cheap stock will likely fuel most of your investment profits.
Disclosure: I own shares of DTV in a personal investment account.