Stock Buybacks or Dividends?

06/16/2011 7:30 am EST

Focus: STOCKS

Kelley Wright

Managing Editor, Investment Quality Trends

About midway through each calendar quarter, the question inevitably arises whether stock buybacks or cash dividend payments provide investors with the greater benefit, notes Kelley Wright of Investment Quality Trends.

Like most investing issues, there are two definite schools of thought that pertain to these two methods of enhancing shareholder value.

With a share buyback, the number of shares outstanding is decreased. With fewer shares outstanding, the company’s metrics—by example the P/E ratio and the price-to-cash-flow ratio—will improve. Going forward, this should provide a boost in value to the remaining shares outstanding.

According to Standard & Poor’s, the number of buybacks among the 500 companies that comprise the S&P 500 index were up significantly ($90 billion to be specific) in the first quarter of 2011 versus the same period in 2010. With that level of activity, one would expect to see a noticeable bump in share prices.

In reality though, the current round of buybacks have not resulted in the same degree of share-price increases seen historically as a result of the buybacks. Why is this?

The simple answer is that the share count is not really going down. The fact of the matter is that many companies constantly issue shares as part of employee compensation.

So while they may be buying back shares on one hand—which the press loves to tout—they are issuing shares on the other hand, which often goes unreported or under-reported. At the end of the day, in many cases, the net result is a wash.

As you might expect, our preference is the cash dividend.

  • First and foremost, the cash dividend is a return on investment, the sole purpose of putting capital at risk.
  • Second, the cash dividend tells us much more about a company than its balance sheet or profit-loss statement.

The dividend is paid from profits, or earnings if you prefer. A company that pays dividends, therefore, is profitable. If a company has a rising dividend trend, it stands to reason that there must be a sufficient increase in earnings to justify the dividend increases.

A company that consistently increases its dividend is also consistently increasing the value of each share to the shareholder. As such, the share price should consistently move higher to reflect this increasing value.

A long-term history of dividend payments and dividend increases also provides a floor of safety beneath a stock’s share price. This is not to suggest that the dividend makes a stock’s price immune to a broad market sell-off, but a repetitive area of low-price and high-yield alerts investors when a significant area of good historic value has been reached.

When a high-quality company with a long-term track record of dividend payments and dividend increases offers excellent good value, large sums of investment capital will flow into the stock, which halts the decline. Buybacks do not provide this form of support, nor do companies that do not pay a dividend.

In our estimation, buybacks are often implemented when the share price is too high. As such, we would prefer to receive the cash and then buy shares in another company that offers good historic value.

If you will remember, stock buybacks were all the rage in 2007 and even into 2008. For many companies with ongoing buyback programs, shares were purchased at the top of the market. Needless to say, this capital could have been spent in a much wiser fashion.

All things being equal then, as shareholders—the real owners of the company—we would prefer that our companies reward us with cash and let us make our own managerial decisions as to the best avenue to deploy that cash.

Remember, no one knows your personal situation better than you, and no one cares about you more than you.

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