With interest rates near zero, there is virtually no value created for shareholders by holding a lot of cash, and this has left many companies with a desire to return the cash to shareholders. But how to return the cash has become the great debate. Dividends or stock buybacks, which method of returning cash to shareholders is superior? Each has its own advantages and disadvantages. In some cases one is clearly preferable over the other.
Let's look at each, and you can decide which is best for you.
Buybacks Are More Tax Efficient - When a company buys back shares, each shareholder's ownership interest rises ever so slightly without any tax consequences. Dividends paid are taxed at 15% if they are from a qualified stock, otherwise they are taxed at taxpayers' marginal tax rate. The resulting increased ownership in a company from a share repurchase is tax free.
Buybacks Offer Companies More Flexibility - Once a dividend is put in place, it is a big negative for the company to decrease, eliminate or fail to grow the dividend over time. However, if a company slows down or stops repurchasing shares, it is hardly noticed. With buybacks a company can simply shift its spending as needed.
Buybacks Offer A Means To Support Share Price - Companies with buyback programs in place can use market weakness to buy back shares more aggressively and thus support the company's falling share price by creating demand for the stock.
An Expectation of a Growing Dividend Puts Pressure on Management to Act Responsible - To pay next year's higher dividend management must grow cash. The expectation of a higher dividend doesn't go away if the high-risk investment fails. Management must behave in a more diligent, responsible and calculated manner to consistently grow its dividend.
Dividends Show Management's Confidence - When a company pays an increasing dividend, it shows management's confidence in the company's future cash flows. No CEO wants to be the engineer of a train wreck. Cash used to pay dividends can't be faked - it must be earned, borrowed and/or raised by selling shares. A prudent dividend investor knows how the company is funding its dividend.
Dividends Benefit Shareholders - When a shareholder receives cash, he or she is free to use it any way they please, including paying living expenses or buying additional shares of the company. An example of stock buybacks benefiting executive management to the detriment of shareholders is when management uses share buybacks to increase EPS to meet a bonus target at a time the stock is overpriced.
Dividends Can Decrease Price Volatility - If you are holding shares in a solid company and the market tanks, why would you sell. You are getting paid to hold the stock. With a lower share price, adding additional shares in the solid company will provide you a higher yield than before the share price declined. In this case, investors have an incentive to hold their shares and even buy more which in turn will support the stock's price. Shareholders are not just hoping management is acting in their best interest by buying shares during a time of weakness.
An Insider's View
In a February 2012 Wall Street Journal article, the financial newspaper interviewed two Wall Street personalities with strong views on dividends vs. share buybacks: Whitney R. Tilson, the founder and managing partner of T2 Partners LLC, a New York hedge fund, and an outspoken proponent of share repurchases; and Gregory V. Milano, the co-founder and chief executive of Fortuna Advisors LLC, a corporate-finance consulting firm based in New York, who rarely encounters a buyback he considers the best use of a company's cash.
"... that most companies do not think or act sensibly regarding share repurchases and therefore end up destroying value. It never ceases to amaze me-and, when a company we own does the wrong thing, infuriate me-how few companies think sensibly about this topic and thus buy back stock for all the wrong reasons: to prop up the price, signal confidence, offset options dilution, etc."
MR. Milano noted:
"Though some are successful with share repurchases, the evidence overwhelmingly shows that heavy buyback companies usually create less value for shareholders over time. The problem with buybacks is considerably compounded by poor timing: the propensity to buy when the price is high and not when it's low. A measure called buyback effectiveness compares the buyback return on investment to total shareholder return, and indicates whether the company buys low or high relative to the share price trend. From 2008 through mid 2011, nearly two out of three companies in the S&P 500 had negative buyback effectiveness."
The Stock-Buyback Trap
In a 2007 analysis done for CFO magazine by The Boston Consulting Group [BCG] the study found that stock buybacks can play a role in boosting near-term returns for some companies, but the firm's research indicates that buybacks do not change investors' estimates for long-term earnings per share growth, or induce them to accord a company a higher valuation multiple.
By contrast, it says, dividends have a far more positive long-term impact. In a study of 107 companies that boosted their dividend and another 100 that announced an increase in share repurchases, the dividend payers saw their multiples go up over the next two quarters by an average of 28 percent and the top-quartile performers by an average of 46 percent. In comparison, the buyback companies saw their valuation multiples erode on average and top-quartile improvements averaged only 16 percent.
In short, BCG argues that buying back stock doesn't deliver much in the way of long-term value, meaning that corporate executives must still find ways to differentiate their companies from their competitors and demonstrate that they can deliver profitable, above-average growth.
In a perfect world of benevolent CEOs acting solely in the best interest of their shareholders, share buybacks would provide higher value by reducing the tax inefficiency of dividends. But until that perfect world arrives, I want a large part of the cash returned to me in the form of growing dividends.
Below are several core dividend growth stocks that I rely on to provide my portfolio income and wealth appreciation:
Johnson & Johnson (NYSE:JNJ) is a leader in the pharmaceutical, medical device and consumer products industries. The company has paid a cash dividend to shareholders every year since 1944 and has increased its dividend payments for 52 consecutive years. Yield: 2.6
The Coca-Cola Company (NYSE:KO) is the world's largest soft drink company. KO also has a sizable fruit juice business. The company has paid a cash dividend to shareholders every year since 1893 and has increased its dividend payments for 52 consecutive years. Yield: 2.8
Exxon Mobil Corp. (NYSE:XOM), formed through the merger of Exxon and Mobil in late 1999, is the world's largest publicly-owned integrated oil company. The company has paid a cash dividend to shareholders every year since 1882 and has increased its dividend payments for 32 consecutive years. Yield: 2.9% See full analysis.
McDonald's Corporation (NYSE:MCD) is the largest fast-food restaurant company in the world, with about 35,000 restaurants in 119 countries. The company has paid a cash dividend to shareholders every year since 1976 and has increased its dividend payments for 37 consecutive years. Yield: 3.6%
AT&T Inc. (NYSE:T) provides telephone and broadband service and holds full ownership of AT&T Mobility (formerly Cingular Wireless). The company has paid a cash dividend to shareholders every year since 1984 and has increased its dividend payments for 31 consecutive years. Yield: 5.4%
Full Disclosure: Long JNJ, T, XOM, KO, MCD, in my Dividend Growth portfolio. See a list of all my dividend growth holdings here.
Disclosure: The author is long JNJ, T, XOM, KO, MCD.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.