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I am a huge fan of dividends. I am a bigger fan of share buybacks. Our whole investment model at my firm is founded on the idea of dividend payments, so this article is in no way intended to trash dividends.

To start, I want to address some of the common points most proponents of dividends use in the case against buybacks.

1. Share buybacks are ill-timed by management.

2. Share buybacks only reward those who are selling, not buying.

3. Share buybacks are just a way for insiders to cash out of their options at the expense of the other share holders.

Let's get started.

1. Share buybacks are ill-timed by management - This seems, on the surface, like a very good point. There are many articles when individual examples are given of a company buying back stock near the high, only to see the stock price collapse. A recent example would be Netflix (NASDAQ:NFLX). Netflix management purchased stock at higher and higher prices, then sold at much lower prices once they needed the money. From Bespoke Investment Group:

The part that is missed in an example like Netflix, is that the stock was already over valued. Both investors and management were overpaying for the shares compared to the cash flow and business model of Netflix. Not all management buybacks are bad. They, like you, must invest in companies that have good value for their investment.

In the long term, stock buybacks are no different than dollar cost averaging for investors. If the company paid a dividend every three months that is automatically re-invested by shareholders, chances are, some of those re-investments will be at unfavorable long term prices. That is the nature of automatic investing. The case for stock buybacks being badly timed is a case against dollar cost averaging.

2. Share buybacks only reward those who are selling, not buying and holding. - This, in my opinion, is the weakest of the arguments presented. Buying back stock from weak hands is not a bad thing. Most likely, the company treasury itself is probably the strongest hand in the game, assuming the company will not need the cash in the near future. As a shareholder, I would much rather have shares move from the hands of Scaredy Scott and Frightened Freda, to the company, who most likely will hold those shares for very long periods of time. I don't need to worry about those weak hands getting scared in a panic and crushing the share price of my holdings when they sell without thinking.

Assuming the company maintains the same amount of business in following years, my shares will now get a bigger piece of the cash flow, as there are now less shares sharing the same cash flow. If the company grows their business, my shares will see a growing amount of wealth being generated per share that I own. There are many other reasons why I don't think this buying out the weak hands is bad, but for the sake of space, I'll save that for later.

3. Share buybacks are just a way for insiders to cash out of their options at the expense of the other share holders. - This is another argument I don't quite get, once I think about it further. On the surface it seems logical. But carry this thought out to its conclusion. The options have been granted already. The future claims on the business have already been made. The issue is in the granting of options in the first place. The issue is not how management cashes out. If a company didn't use cash flow to buy out the options that are being exercised, then the options could be converted to shares, thus diluting me all the same. Those converted shares are then sold on the open market, which might create greater volatility, thus causing the panic for the weak hands I mentioned earlier. Is there really any difference in the long run of using cash flow to cash out insiders, or having the insiders dump shares on the open market? I would argue it's the same.

This brings me to my next argument in the defense of share buybacks. We must first understand that all dividends and share buybacks should be derived from the cash generating ability of the company, Free Cash Flow (FCF) if you will. This is the cash left over after spending on capital expenditures needed to run the business. It is shareholder take home pay. Dividends, share buybacks, and debt payoff should come completely from FCF. Be wary of a company paying a dividend from the cash received due to stock issuance, or by taking on more debt. That is no different than you taking a cash advance on your Visa.

When a company decides to pay some of this Free Cash Flow to shareholders in the form of a dividend, shareholders have a few options of what they can do with that cash.

-They can re-invest the dividend into more shares of the same company.

-They can spend the cash.

-They can invest the cash into a different company or investment (real estate, bonds, etc.)

Being able to spend the cash on living expenses, or having the option to invest in a different stock, in my opinion are the two biggest advantages of a company paying a dividend instead of buying back stock. It gives the shareholder control over where shareholder earnings are allocated. If that same shareholder chooses to re-invest those dividend payments into the same stock though, they are at a great disadvantage compared to a company buyback.

When a company pays a dividend in the form of cash, a taxable event takes place. When the investor receives that dividend in a taxable account, they lose 15% of their payout benefit to Uncle Sam. If they are re-investing those dividends, they will be able to buy 15% less stock than the value they would have received from a share buyback instead because of that tax bite. They will also have to pay a transaction fee to their broker in order to buy those shares. For tax deferred accounts where the shareholder wants to re-invest dividends into the same company, the shareholder will still have a transaction fee that would not be there had the company just bought the stock through a share buyback plan.

Take a look at this example with Exxon (NYSE:XOM) that I just sent to a client in an email:

In the past 4 quarters, XOM has generated $27.6 billion in FCF. The market cap of XOM is $390 billion. They could technically use 100% of their free cash flow and pay it out in the form of a dividend. That is the equivalent of a 7% yield.

You have to really look at a company like XOM and the FCF to determine the true yield. Instead of paying out the whole $27.6 billion in investor earnings as a dividend, over the past 4 quarters, they have paid out $9.28 billion of the FCF as a dividend, and the rest of the FCF they used to buy stock back.

Here is where buybacks start to make sense.

Imagine that Exxon paid out the whole $27.6 billion of FCF in the form of a dividend and all the shareholders re-invested those dividends to buy more Exxon shares. If that were to happen, after taxes, the shareholders would only have $23.46 billion of cash left to buy more shares. Due to the dividend event, the shareholders lose $4.14 billion of wealth, never to be seen again, as it goes out of the company to Uncle Sam. Doing it the way Exxon does it, most of the FCF gets re-invested in the shares on behalf of the existing shareholders, and only $1.39 billion is lost to taxes (assuming non-qualified accounts for all shareholders in this example)

The bottom line is, XOM has roughly $3 billion more value (almost 1% of the company) in the current FCF payout structure, compared to paying out all the FCF in the form of a dividend. Keep in mind that you do not need to pay the transaction fee to buy the stock either.

I think the biggest point to be made is this line:

Due to the dividend event, the shareholders lose $4.14 billion of wealth, never to be seen again, as it goes out of the company to Uncle Sam.

Imagine if 100% of the investors took the $23.46 billion of after tax cash flow and spent that money elsewhere. XOM's capital structure would be not nearly as strong. By spending $21 billion on buying their own shares, the cash has, in essence, left the company because it leaves Exxon's bank accounts and shows up in the accounts of the selling stockholders. The difference is the company received back billions of dollars of shares that can be re-issued at a further date if needed. Buybacks provide benefit to the capital structure, thus bringing value to shareholders, whereas dividend payments don't necessarily do that.

Lastly, I found this weak but potential proof for the case of buybacks over dividend payers:

This chart shows the Powershares Buyback Achievers (PKW, green line) as the green line vs. Powershares Dividend Achievers (PFM, blue line), as well as against each other as well as the S&P 500 (NYSEARCA:SPY) and Dow 30 (NYSEARCA:DIA) indexes.

The Buyback Achievers ETF Index is designed to track the performance of companies that meet the requirements to be classified as BuyBack Achievers™. To become eligible for inclusion in the Index, a company must be incorporated in the U.S., trade on a U.S. Exchange and must have repurchased at least 5% or more of its outstanding shares for the trailing 12 months. The Fund is rebalanced quarterly and reconstituted annually.

The Dividend Achievers ETF index is designed to identify a diversified group of dividend paying companies. These companies have increased their annual dividend for ten or more consecutive fiscal years. The portfolio is rebalanced quarterly and reconstituted annually.

As you can see, since January 2007, the Buyback Index has trumped the Dividend growers index by quite a bit. The share buyback index is the only index in positive territory since right before the credit crisis. This doesn't prove my point in this article, but it is an interesting data point in comparing two different strategies that mimic buybacks and dividend payouts.

To conclude, an investor must ask - which is better for me? If you are in need of income payments now, in order to pay bills like electric, medical, housing, food, energy, etc., then you probably would prefer to have dividends in order to have the free cash to meet those demands. For those who won't be needing the money for a long time, and are wanting to build their investment accounts, you are better off avoiding the tax one must pay on dividend payments, and just let the company automatically re-invest your free cash flow into new shares on your behalf. Even if you invest in a qualified account, it is still a cost savings to not have to pay a transaction fee to re-invest the companies cash flow into more shares. Just let them do it on a transaction free basis for you through their buyback plan.

If you can find a great company that offers a DRIP program that is transaction free, especially one that offers to sell stock at a discount, there probably isn't a better option for your money long term in an IRA. The best option is to find a company that has a long history of increasing dividend payments, as well as stock buybacks. XOM and Wal-Mart (NYSE:WMT) would fit that bill.

Disclosure: I am long XOM, WMT.

Source: Dividends Vs. Buybacks: Putting The Debate To Bed