The Case For Stock Buybacks vs. Dividends

by: Roger Ehrenberg

I have long been a proponent of stock buybacks as a vehicle for returning cash to shareholders. The RIGHT amount of cash. I think dividends are fine, too, but come along with too much excess baggage.

Once dividend policy is established, the payoff to shareholders becomes asymmetric: if dividends are flat or grown a little each year, great, that is expected; if they are dropped because of a bad quarter or a bad year, look out. This leads to "sandbagging," or setting a dividend at a level that is so far below a corporation's ability to return cash to shareholders that it becomes almost meaningless.

Let's face it, dividends are becoming marginalized, especially as institutional investors rule the landscape and retail investors become less of a presence from a funds flow perspective. I've argued this several times in the past, getting downright brutal with the New York Times in November of last year and pretty horsey with Barron's this past May.

But now finally a voice of reason has come to save the day, which simply means agreeing with my position on the topic, and it comes from Douglas J. Skinner of the University of Chicago GSB in a study discussed in this weekend's Barron's:

Skinner finds that stock buybacks are now being used as substitutes for dividends, even by companies that continue to make payouts. The reason for that appears to be the increased volatility of earnings.

In some ways, says Skinner, repurchases are the superior choice for the issuer because "there's total flexibility with stock repurchases, whereas you're committed forever with a dividend." For obvious reasons, companies want to avoid cutting or omitting their payouts. "With repurchases, you could pay out $3 period and zero the next."

So while corporations that have been paying dividends for decades continue to do so, their dividend policies are becoming more conservative, and they're more frequently rewarding investors with buybacks. "If a firm has unusually high earnings one year, they're not going to increase dividends; instead, they make a large stock repurchase," declares Skinner.


Although it can be argued that dividends are barometers of earnings quality, he says there's not much evidence to support that. "The main contribution of this study is the substitution hypothesis -- determining if stock repurchases are actually used as substitutes for dividends. If this is the case, stock repurchases should be linked to earnings." Skinner notes that the relationship between dividends and earnings has become weaker in recent decades, largely because managers now set dividends in a mechanical way -- with small, predictable increases.

Two key points are raised here that I believe drive the buybacks vs. dividends decision - flexibility and uncertainty. The setting of a dividend might be theoretically logical for a company with a high level of annuitized revenues that are highly predictable, but this simply doesn't describe the cash flow characteristics of most companies. Economies go through cycles. Shocks occur. Products obsolesce and aren't immediately replaced with superior models. The competitive landscape shifts. There are countless reasons why earnings don't grow in a straight line, and sometimes even fall.

And this in and of itself doesn't mean a company stinks; it means that it's not impervious to outside influences. Therefore, creating corporate finance policies that are flexible, adaptable and take into account uncertainty seem to fill the bill in an increasingly complex and volatile world. Here are just a few of the things I noted in my earlier discussions of the topic:

From my May 2007 post concerning the market's perception of share buybacks:

Corporations like buybacks because they are flexible, can be used to soak up short-term excess cash as well as to facilitate a more optimal capital structure, and because of the signaling effect they can have on management's view of business prospects. I don't think corporate managements really believe that institutional investors are as dumb as Mr. Bary would have you think.

Given my knowledge of corporate finance departments and their decision-making processes, I am pretty confident that the reasons I raised for why buybacks are used are more on point, IMHO.

So while we can prattle on about what should and should not be, the market is saying something: that the current dividend vs. buyback policy is just fine, thank you. And while we can debate the point on a theoretical basis, the fact that the two strategies are tax-neutral and that institutions seem to like the discretionary and signaling aspects of buybacks means that things are unlikely to change. Until institutions begin stand up and begin voting with the pocketbooks, that is. Which means a change in the market. Which is the way things should be, not the way some people think things should be in the financial media eco-chamber. Let us always remember: Mr. Market rules, now and forever.

From my October 2006 post concerning the impact of volatility and financial distress on cash balances:

We essentially ran models that looked at precisely the things mentioned in the study above - namely, the volatility of a company's cash flows, its relationship to economic cycles, potential changes in business mix and its impact on the characteristics of future cash flows, quantifying what constituted "financial distress" and arriving at a recommendation for a base level of cash or near-cash that should be held to cover this risk. We specifically looked at companies that generated large amounts of cash - technology companies, telecommunications companies, regulated utilities, etc. - and advised managements on corporate finance policies like stock buybacks, dividends, and long-term debt issuance strategies. I will tell you that this type of analytical framework resonated with Treasurers and CFOs alike, and had a real impact on how many companies managed their cash - in some cases, gaining the comfort to increase their dividends/share buyback programs, while others chose to issue long-term debt to build the necessary cushion to most efficiently take the tail risk of financial distress off the table.

In sum, corporations want the flexibility to reward shareholders when it is prudent to do so and in amounts that are consistent with the company's financial strength and growth plans. Dividends don't afford managements the same levers to operate in a dynamic way, rendering it a far less appealing alternative than buybacks. I am happy that Mr. Skinner's study made clear what many of us already knew to be intuitively true, that buybacks are simply a better way to optimize capital structure, manage cash and return capital to shareholders. They just are.