Providing returns to shareholders can be accomplished in many ways. The best way is through re-investing cash flows to grow the revenues and profits of the business, increasing the intrinsic value of the firm's common stock. However, many companies operate in limited markets or are mature businesses with limited opportunities to re-invest cash at attractive rates to generate growth. In these situations, there are two additional options. One is to simply pay out excess cash flow to shareholders in the form of a dividend. The second option is to buy back shares of common stock and retire them, providing current shareholders a larger slice of the profit pie.
A dividend in most cases is the more attractive option. Dividends provide a tangible return on investment, often at higher yields than can be attained through "safer" investments like bonds or treasuries. Also, dividend payments can be raised, and it is usually a priority of company boards to avoid cutting or eliminating a dividend.
Share buybacks are a decent alternative. For one, they are tax efficient - investors receive a larger portion of cash flow without having to pay Uncle Sam, as he/she would with a portion of the dividend payment. However, share buybacks only make sense if the company believes their shares are trading at a significant discount to intrinsic value. Too often they are utilized instead to "cover up" excessive stock option or restricted stock grants to executives. Where this is not the case, a repurchase announcement can often signal that management believes its stock is undervalued. Who knows more about the business than management itself?
Dividends and share buybacks also provide another security for Magic Formula Investing (MFI) adherents, where many of the uncovered stocks are unknown, un-followed small caps, many with short histories, and several operating overseas. Over the past year or so, MFI has had a tendency to dig up Chinese small-cap stocks, with excellent reported cash flows and balance sheets, but intense allegations of fraud. Share buybacks or dividend payments are bullet-proof evidence that those cash flows are quite real. It offers piece of mind to an investor in a stock.
MFI is designed to dig up excellent companies (high returns on capital) trading at bargain prices (high earnings yield). Under these simple assumptions, it makes sense for these companies to invest their cash flows into buying back stock at low valuations. Here are the companies in MFI's top 50 over 50 million market cap that have returned significant amounts of cash flow to shareholders over the past year or so:
CSG Systems (CSGS): $33mm in repurchases over the last 6 months.
Raytheon (RTN): $470mm in dividends a year (3.2% yield), $525mm repurchases in last 6 months, $1.2 billion in repurchases last year.