Wednesday, August 31, 2011

Are Dividend Investors Benefiting from Stock Buybacks?

Corporations typically return cash to shareholders in two ways – through share buybacks or in the form of dividends. In a previous article I compared and contrasted both methods of returning cash to shareholders.

My analysis of Chubb (CB) spurred a lively discussion among readers, some of which use Net Payout Yield. The net payout yield represents the total amount of cash paid for dividends and spent on share buybacks, divided by the market value of the company. Some investors believe that this should be taken in consideration, whenever someone analyses a stock.

Rather than take these readers words for it, I decided to crunch some numbers. I noted that Chubb (CB) has spent the following amounts for share repurchases over the past 4 years: ( in millions of $)



The most interesting part in this exercise is that the highest price for Chubb stock was $66 reached in 2011. Before that, the highest price was in 2008 at $65. What the company is not showing is that it is repurchasing shares, yet it is also issuing shares most probably to executives who have chosen to exercise their stock options at ridiculously low prices.

The company has spent $1.88 billion on dividends over the past 4 years. However, it has spent $6.24 billion on share repurchases. It spent 3.30 times more on buybacks than on dividends.

An investor with 4.23 million shares in 2006 would have owned 1% of the entity, whereas now they would own 1.30% because of the anti0dillutive effect of share repurchases. However the stock ended 2006 at $53. Had all the cash been paid out as dividends, the investor would have received $19 in dividends/share over a 4 year period (for a 36% return). ( I get to $19 by adding up 1,881 billion spent for dividends and the 6,237 billion spent for buybacks and assuming the number of shares stayed constant, and then dividing by 423 million shares).

Instead, the investor received $5.36 in dividends in total for 2007, 2008, 2009, and 2010. The stock closed 2010 at $60. So the total return was 23%.


I also analyzed three of the largest dividend paying stocks, which repurchased massive amounts of stock over the past several years. The companies include Wal-Mart (WMT), Exxon-Mobil (XOM) and IBM (IBM).

ExxonMobil (XOM) shareholders would have received $21.61/share between 2007 – 2010 has all the cashflow been returned in the form of dividends (for a 28.20% return). Instead, shareholders received a paltry $6.32/share over the 2007-2010 period. The stock closed 2006 at 76.63and traded at 11.60 times earnings. The stock closed 2010 at 73.12 and traded at 11.80 times earnings. The amounts paid per each repurchased share appear reasonable. The increase in share count in 2010 was prompted by the acquisition of XTO energy. Check my analysis of XOM.



Wal-Mart Stores (WMT) shareholders would have received $11.82/share between 2007 – 2010 has all the cashflow been returned in the form of dividends (for a 25.30% return). Instead, shareholders received a paltry $4.13/share over the 2007-2010 period. The stock closed 2006 at 46.18 and traded at 17.40 times earnings. The stock closed 2010 at 53.93 and traded at 12.90 times earnings. When looking at the amount paid per share over the past 4 years, investors should remember that the stock price never went above $63 during our study period. While the share buybacks might not have been beneficial to ordinary WalMart (WMT) shareholders, they have been helpful for the Walton family. The Walton family stake in Wal-Mart has increased to above 50%, mainly due to the fact that the family is holding on to their stock, while the company is using shareholder’s cash to repurchase stock held by others. Check my analysis of WMT.



It seems that IBM (IBM) shareholders would have received $40.53/share between 2007 – 2010 has all the cashflow been returned in the form of dividends (for a 41.70% return). Instead, shareholders received a paltry $8.05/share over the 2007-2010 period. The stock closed 2006 at 97.15 and traded at 16 times earnings. The stock closed 2010 at 146.76 and traded at 12.70 times earnings. The amounts paid per each repurchased share look particularly out of line, given the fact that IBM never traded above $150 until early 2011. Check my analysis of IBM.



Of course, over the long term, (after 10-20 years), the price of each of the stocks mentioned above would be much higher than what it trades for today. As a result, the partners in the business who sold below at current prices would be kicking themselves for their sell decisions between 2007 -2010. However, the partners in the business who held on to their investment would have seen this share repurchase as a smart option.

To summarize however, I would much rather receive special dividends, than get share buybacks.

Full Disclosure: Long CB, WMT, XOM

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8 comments:

  1. I like the article, and it could spur some theoretical discussion. The net payout yield at first glance seems nice, but what about share issuance, stock option etc.. It is a crude measurement of actual company ownership. I think it is good to see where a company is deploying its cash. I like to list a sources/uses of cash table in my analyses. The only drawback to the net payout yield is that a company could issue a lot more shares than it buys back over a yearly period.. Any thoughts?

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  2. Your conclusion depends upon the *significant* assumption that the total shares outstanding is constant during the "what if" scenario. As you point out at the top, corporate stock buybacks often offset stock grants/options which would otherwise be dilutive. For the purposes of the "what if" comparison, you must assume the company still created new, dilutive shares, but just did zero buybacks and redirected that cash to dividends instead. After the each year, the dividend/share would necessarily shrink.

    Another way to look at it: suppose the company didn't issue stock grants at all, but instead paid higher salaries. There would be no dilutive effect, and no need for buybacks that exist purely to offset grants. But that'd also reduce earnings, which would still reduce cash available for dividends.

    I think the dividend vs. buyback exercise is a good one. I don't agree that you can penalize the buyback scenario by assuming constant shares in the all-dividends scenario.

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  3. I've been looking around for a more rationalized source for this data. I would pay a fee to see a third party review showing the net effects of buyback to shareholders for a universe of dividend paying stocks. Management will argue that their compensation and company performance are well correlated. If so, such effect might be taken into account for all to see.

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  4. Lets face it. Stock buy backs help feed the looting of the treasury for the benefit of those receiving those all mighty stock grants. If it was done out in the open stock holders might pay a little more attention. How many of these grand buybacks have been done when you or I would buy these stocks??? It seems that buy high or higher is the order of the day. Any fool can do that at the expense of someone else. I'll take the cash and direct it as I wish thank you very much.

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  5. Thanks for the article. There are few better ways to settle a dispute than to crunch the numbers.

    However, I see two main issues. The first is smaller, but sometimes significant: Only NET share repurchases represent returning value to shareholders. One must subtract share issuances from buybacks to get a more accurate picture of what is going to shareholders.

    The larger issue is certain statements in the post. For instance, you reference Walmart's static stock price and how investors didn't benefit, but one must realize that without share repurchases, the current EPS would be significantly lower, and if the same valuation was applied, the stock price would be lower. Share repurchases had an invisible effect on keeping the share price up. Theoretically, if they had paid this out in dividends and an investor had reinvested them, the shares today would be worth less, but the investor would have more of them, and would have paid more dividend taxes, leaving less for reinvestment.

    The two most powerful arguments against share repurchases are: poor timing (which can sometimes be mitigated by companies like these that repurchase shares rather consistently), and conflict of interest (where executives use share repurchases to further their own goals, rather than to truly create shareholder value).

    In the current period of unusually low dividend taxes, I'd usually prefer special dividends too. I appreciated HGIC's 2010 special dividend, and appreciate NPK's annual special dividend. But for companies like WMT, XOM, CB, IBM, and MSFT, I'm satisfied with the share repurchases because the shares are at a lower enough valuation where for those I own, I'd want to reinvest dividends anyway. On the other hand, an example of a bad strategy of share repurchases is Costco, since they're spending so much on share repurchases when the stock is at such a high valuation, and therefore getting a rather terrible rate of return on that capital.

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  6. Dividend Monk,

    Investors in WMT would have been better off receiving dividends vs having shares repurchased. Just notice how the P/E ratio contracted from 17.40 to 12.90. Market participants are not stupid - they reward companies who can increase EPS through organic growth or acquisitions, not financial engineering.

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  7. If WMT had not bought back shares, EPS would be significantly lower than it currently is, and EPS would grow more slowly.

    Investors would then like the quality of that EPS growth better, since it's all organic or acquisition related, but due to the reduction in growth, a lower multiple should be placed on it. Growth is growth.

    Between 2002 and 2011, company net income grew by 10.5%. During the same time period, EPS grew by 13%, and that extra is due to share repurchases. If WMT had not done share repurchases, but instead paid that money in larger dividends, then EPS would have grown by 10.5%, and today that EPS would be $3.66. In order for WMT to have the same stock price, the valuation must be substantially higher, despite slower EPS growth. More realistically, the stock price would be lower, but investors would have received larger dividends, and if they had reinvested, would own a greater number of those cheaper shares. And the dividend growth rate would have been 15.1% instead of 17.6%, albeit with a higher yield.

    Now, it's reasonable to debate the extent to which buybacks benefit shareholders compared to dividends (discussions of conflicts of interest, whether executives time the purchases right, what the rate of return is on that capital, what the tax rates on dividends are, how it affects investor psychology, etc.) But they do have a quantitative effect. Timing and tax issues aside, reinvested dividends and net share repurchases result in investors increasing their ownership percentage of the company at the same rate. For WMT, I'd prefer they double the dividend to 4% or 5% yield, and continue the buybacks for the rest of their extra capital.

    Currently, with dividend tax rates so low, paying more in dividends than share repurchases makes more sense, but if the reduced dividend tax ever expires, I'd prefer not to be paying 20-35% taxes on all of the capital that my company wants to return to me, when some of it could be untaxed as repurchases with the same quantitative effect, at least when I'm in the accumulation phase.

    I once wrote an article to compare, if you're interested:
    http://dividendmonk.com/dividends-vs-share-repurchases/

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  8. DM,

    In WMT's case, the shareholders would have been better off getting dividends than getting share buybacks. The P/E contracted by a lot, whereas the cash in the hand retained its value (if kept in the bank). Even if you reinvested dividends, you would have been better off.

    I do think that stock buybacks are not too bad, as it decreases number of shares outstanding thus increasing the remaining shareholder's ownership percentage. In the long run, I think WMT would keep increasing earnings over time even without buybacks. This would make the business more valuable. And if there are less shares outstanding, this would make my ownership percentage higher and more valuable too ( in the long run).

    Mostly, buybacks have aided the Walton family in buying out other shareholders using company's money, therefore making the company own more than 50% of the business.

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