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Many investors view stock buybacks and dividends as an either/or proposition when debating how companies can best return a share of its profits to shareholders. Proponents of stock buybacks note their tax advantages relative to dividends, while proponents of dividends value receiving their share of profits as cold, hard cash. In my opinion however, the best strategy is to find companies that provide both a growing dividend and a significant amount of stock buybacks (Note: I am only referring to companies that carry out net stock buybacks, reducing the overall number of shares outstanding).

This strategy can be very successful as dividends and stock buybacks both have complementary qualities that can be used together effectively. Ideally, dividends force financial discipline on a company by requiring it to deploy capital efficiently in good times in order to provide shareholders with growing dividends year after year. On the other hand, during times of financial stress companies may delay cutting a dividend to avoid the wrath of shareholders, even if a dividend cut would best serve the long-term health of the company. Stock buybacks have opposite characteristics, failing to enforce as much financial discipline on a company as dividends in good times but providing greater flexibility during bad times.

Selecting stocks that embrace both growing dividends as well as stock buybacks is effective precisely because of the dynamic described above. Even during good times with large increases in profits, a company might be conservative in increasing its dividend because of the difficulty of maintaining an elevated dividend payment during future bad times. In this case, the company might be wise to raise its dividend by a comfortable amount while using the rest of its excess profits to buy back shares rather than letting them sit in a pile of cash earning virtually zero interest. By reducing the number of outstanding shares, these buy backs will further enhance opportunities for future dividend growth. Future earnings will be distributed over a smaller number of shares, and the amount of these earnings allocated to dividends will likewise be distributed over a smaller number of shares. In this way, dividends can grow faster than they otherwise would.

To illustrate this effect, consider a company that both grows its dividend and buys back significant amounts of stock: Philip Morris International (NYSE:PM). According to data freely available at Morningstar, Philip Morris International reduced its number of shares outstanding by roughly 5% per year between 2008 and 2011. This period also witnessed a large amount of dividend growth, from $1.54/share in 2008 to $2.82/share in 2011 (to be fair, PM only paid dividends for three quarters in 2008, but the overall trend remains valid). Let's consider two future scenarios for PM, one where dividend growth is not supplemented by stock buybacks and one where it is.

In the first scenario with no further stock buybacks, let's assume that PM maintains the same organic growth rate of overall net income of 13% that it maintained from 2008 to 2011. Furthermore, let's assume that the company wants to maintain the same payout ratio that it had in 2011 of 58% (all historical data about PM again taken from Morningstar). In this case, dividend growth would also be 13%, matching earnings growth exactly in order to preserve the same payout ratio. The dividend would rise from $2.82/share in 2011 to $5.22/share five years from now in 2016.

Scenario 1: No stock buybacks

Year

Shares Outstanding

Net Income

EPS

Dividend

Dividend Growth Rate

Payout Ratio

2008

2078

6890

3.32

1.54

46%

2009

1950

6342

3.24

2.24

45.5%

69%

2010

1842

7259

3.92

2.44

8.9%

62%

2011

1762

8591

4.85

2.82

15.6%

58%

2012

1762

9708

5.51

3.20

13.6%

58%

2013

1762

10970

6.23

3.62

13.0%

58%

2014

1762

12396

7.04

4.09

13.0%

58%

2015

1762

14007

7.95

4.62

13.0%

58%

2016

1762

15828

8.98

5.22

13.0%

58%

In the second scenario with stock buybacks that continue to reduce the number of shares outstanding by 5% per year, we will again assume that PM experiences organic growth in overall net income of 13% per year and that it wants to maintain a payout ratio of 58%. In this scenario, dividend growth jumps to 18.9%, ending up at $6.75/share in 2016. By reducing the number of shares outstanding, stock buybacks allow for a much higher rate of dividend growth even with the same overall net income.

Scenario 2: Stock buybacks of 5% per year

Year

Shares Outstanding

Net Income

EPS

Dividend

Dividend Growth Rate

Payout Ratio

2008

2078

6890

3.32

1.54

46%

2009

1950

6342

3.24

2.24

45.5%

69%

2010

1842

7259

3.92

2.44

8.9%

62%

2011

1762

8591

4.85

2.82

15.6%

58%

2012

1674

9708

5.80

3.37

19.6%

58%

2013

1590

10970

6.90

4.01

18.9%

58%

2014

1511

12396

8.21

4.77

18.9%

58%

2015

1435

14007

9.76

5.67

18.9%

58%

2016

1363

15828

11.61

6.75

18.9%

58%

The following graph illustrates the faster dividend growth that would occur in PM provided that the company continues to use excess profits to buy back shares rather than simply accumulating a pile of cash.

Although PM is the best example I can find of a company that has both a history of dividend growth and a history of significant stock buybacks, other candidates for due diligence could include Wal-Mart (NYSE:WMT), Intel Corp (NASDAQ:INTC), and Lockheed Martin Corporation (NYSE:LMT).

Source: Can Stock Buybacks Complement A Dividend Growth Strategy?