Companies have several means through which they share their prosperity with shareholders. Dividends are the portion of corporate profits paid out to stockholders in the form of cash. Share buybacks on the other hand represent cash distributed to existing shareholders in exchange for a fraction of the company’s outstanding equity. While both methods have their pros and cons, when used carefully, they could strongly add to the total returns of long-term shareholders.
Share Repurchases have gained popularity among companies because there's a total flexibility with them, whereas dividend payments require a commitment. With repurchases a company could spend billions buying back its stock in one year, and then spend nothing for the next few years. With dividends however a company that cuts, eliminates or suspends its payment would likely enrage shareholders.
Some investors believe that stock buybacks are the most tax efficient way for companies to return cash to shareholders. Currently, the highest tax on qualified dividend income is 15% for the top income tax bracket. When companies earn money, they pay taxes on it. When companies pay dividends, dividends are taxed again at the individual level.
When companies repurchase their own shares, they decrease the number of outstanding stock available, which theoretically increases the stock value. Some investors consider this to be the most tax efficient method of returning cash to shareholders, since there is no tax on repurchasing shares. These investors seem to forget however that the holders of stock who sold to the company end up paying a capital gains tax on their profit. While not all shareholders sell stocks to companies, which are repurchasing their own stock, the ones that do could end up with a higher tax bill at the end of the day, especially if they were long-term buy and hold investors.
One reason for the increased popularity of buybacks is that companies do not wish to commit to a certain dividend level, since their earnings are volatile. Stocks like Exxon Mobil (XOM) didn’t pay a large dividend during the huge run up in oil prices over the past decade, partly because their executives might have believed that once oil prices stabilized, dividends would have had to been cut in order to account for the new reality. It looks like Exxon Mobil (XOM) managers were correct about using caution in expecting the good times to continue indefinitely. Projections for near term earnings per share are to contract by 50% in 2009 before recovering to only two-thirds of the record earnings numbers from 2008. Check my analysis of Exxon Mobil (XOM)
Some analysts believe that companies use share buybacks as a clever way to offset shareholder dilution from exercised stock options from management. With stock repurchases companies fail to reduce share count due to new issuance of stock to redeem employee stock options. Stock buybacks are typically initiated in good times, when stock prices are high and discontinued in bad times, when stock prices are low, Thus, corporations end up purchasing their own stock at inflated prices, which greatly limits the supposed benefits of increasing the ownership percentage of each share owned by stockholders.
General Electric (GE) is a prime example for this. In 2007 the company spend $12.319 billion buying back stock, which reduced the share count from 10394 million to 10218 million, or a decrease of 176 million shares. This comes out to $70/share, whereas the high and low prices of GE stock in 2007 were $42.15 and $34.50 respectively. This sure tells us that the company gave out at least one hundred million shares through option exercises. Facing a liquidity crunch in 2008 the company was forced to sell $12 billion worth of stock at $22.25/share, much lower than the price is had paid for buybacks over the past 4 years. Back in February 2009, the company cut its dividend as well in order to conserve cash.
IBM is another interesting buyback stock to research further. Over the past decade, the worldwide supplier of advanced information processing technology and communication systems and services and program products has managed to decrease the number of shares outstanding from 1.852 billion at the end of 1998 to 1.339 billion by 2008. At the same time revenues have increased by 18.4% from $87.548 billion to $103.63 billion over the past decade. Earnings per share increased by 116.75% from $4.12 to $8.93, mainly due to share buybacks, since net income only rose by 60.4% from $7.692 billion to $12.334 billion in the process. $100 invested in IBM stock at the end of 1998 would now be worth $130.30 with dividends reinvested, and only $117.4 without reinvestment. Dividend payments increased from 0.11/share in 1998, when the yield was a little less than 0.5% to $0.55/share, for a yield of less than 2.1%.
The company has spent $73 billion on share buybacks, which should have been paid out as special dividends instead. This would have increased the total returns for shareholders by rewarding them with a higher dividend payment, the compounding effects of which could have greatly magnified long-term stockholder returns. I am a supporter of the extra cash being paid out as a dividend, since its contribution to the total returns would have been more visible than share buybacks. Check my analysis of International Business Machines (IBM).
Dividends on the other hand are mostly cash in hand that gives the investors options about their further allocation. They could be spent, re-invested in the same or other stocks or could be placed in a savings account. Dividends are somewhat more predictable and reliable sources of income, especially if you are looking for an alternative income stream in retirement.
Dividends have contributed a large portion of total returns to shareholders. They typically account for 40% of average annual total returns each year and are the only form of returns on investment that shareholders achieve during bear markets. The reinvestment of dividends has accounted for majority of S&P 500 total returns as well over the past century.
Companies that regularly pay dividends impose a discipline on managers to treat cash very carefully and thus make better decisions by adopting projects, which would generally improve the bottom line, without sacrificing return on equity.
It would be much easier for an individual who plans on living off their investments to rely solely on dividends that on hoping that share buybacks would lift the value of his or her stocks. Selling your stocks at the midst of a bear market in order to sustain your lifestyle doesn’t make much sense, yet investors keep cheering the supposed “tax efficiency” of stock buybacks.
I typically treat share repurchases the same way as special dividends. Share buybacks are inferior to dividend payments, as they could be canceled or temporary suspended at any moment, without many investors noticing this. Dividend payments on the other hand are visible to shareholders and cutting or eliminating a payment would certainly create negative publicity for the company. I would much rather see special dividends, rather than stock buybacks, which are a clever way to mask the diluting effect of employee option being exercised.
Full Disclosure: None
- Special Dividends Unlock Hidden Value in Stocks
- Dividends and Stock Buybacks in the news
- Dividend Investing vs Trading
- IBM Dividend Stock Analysis
- Exxon Mobil (XOM) Dividend Stock Analysis
The S&P Dividend Aristocrats index is an elite group of companies, members of the S&P 500, which have managed to increase dividends ...
I just received notification that low cost broker Loyal3 is shutting down, effective May 22 2017. Loyal3 was a decent commission free alte...
In a previous article I discussed that I am on track to have my dividend income cover my expenses sometime around 2018 . I received a few qu...
As part of my monitoring process, I review the list of dividend increases every week. I usually focus my attention to companies that have r...
Last week, I shared the 2017 list of dividend aristocrats . The most common question I received focused on which companies are attractively ...
I look at the list of dividend increases every week, as part of my monitoring process. I then narrow the scope by focusing on companies tha...
This guest post has been written by Mike McNeil, passionate investor, founder of Dividend Stocks Rock and author of The Dividend Guy Blo...
People usually get emotional when the topic of rent versus buy is brought up. One group swears by owning a home, and believes that it is a g...
The Procter & Gamble Company (PG) provides branded consumer packaged goods to consumers in North America, Europe, the Asia Pacific, Ind...
Raytheon Company (RTN) develops technologically integrated products, services, and solutions worldwide. It operates through five segments: I...