Whether is it dividends or share buy backs, in each case the company is using some of its retained earnings to transfer something of value to its shareholders. With dividends, the “something of value” is money itself. With share buybacks, the “something of value” (theoretically) comes in the form of an increase in the value of each share remaining on the market. 

By: David P. Van Knapp 

Both dividends and share buybacks are often cited as ways for a company to “return money” to its shareholders, as if they were functional equivalents. But they are not equivalent at all.

In fact, the only similarity between dividends and share buybacks is that the company uses a portion of its retained earnings to pay for them. If you are a shareholder, that is really your money being managed by the corporation. The Sensible Stock Investor should not be indifferent to which method the company uses to “return money” to its shareholders. Let’s see what the differences are and decide what is better for the Sensible Stock Investor.

Dividends are simple: The company sends you money. Dividends are usually declared quarterly, approved by the Board of Directors, and sent out to shareholders a few weeks later. The Board declares, say, that the dividend will be $1.00 per share. If you own 100 shares, they send you $100. What could be simpler?

Share repurchases are not complex either, but there’s more going on than with dividends. With share repurchase programs, the Board authorizes using some of the company’s retained earnings to buy shares of itself on the open market. The plan might be, for example, that over the next six months, the company will purchase 1,000,000 shares of itself, taking them in-house and therefore off the market. If the stock sells for an average of $20 per share during the program, the company will spend $20,000,000 to buy back its own shares.

Why are these two very different corporate actions often spoken of as equivalent ways to “give money back” to shareholders? Because, theoretically, in each case the company is using some of its retained earnings to transfer something of value to its shareholders. With dividends, the “something of value” is money itself. The company sends you a check. With share buybacks, the “something of value” (theoretically) comes in the form of an increase in the value of each share remaining on the market. After the company buys back X shares, every remaining share is (theoretically) worth more to its owner. The corporate pie has been sliced into fewer—and therefore slightly larger—pieces. The total number of outstanding shares declines, so each remaining share represents a larger percentage of ownership of the company, a slightly larger claim on its future earnings.

OK, say you are a shareholder in the company. Should you care which route the company chooses to send you “something of value”?

Here are the pros and cons of dividends:

• Pro: They are cash in your pocket, real money. There is nothing theoretical about it. You can reinvest that money in the company, or you can do anything else you want with it. You can use it as income.

• Pro: Most dividend programs are tantamount to corporate policy. Companies rarely cut or eliminate dividends. Even though each dividend payout is a separate event, the overall program is sacrosanct at most corporations that pay dividends.

• Pro: Dividends help support a higher share price, assuming that the market places a value on strong dividend programs. Studies show that over long periods of time, the market does place a value on dividend programs.

• Dividends are closely watched and reported, so information about them is easy to obtain. Over time, companies establish dividend patterns which are pretty predictable. Significant changes in the pattern are reported instantly.

• Con: You must pay taxes on the dividends. However, the federal income tax rate of 15% on dividends makes it one of the least-taxed forms of income available.

Here are the pros and cons of share buybacks:

• Pro: Since no money is sent to you, you are not taxed.

• Pro/con: The share repurchase reduces the number of shares circulating, thus increasing the value of the remaining shares. However, to realize this increased value, the market must reprice the remaining shares upwards. The passage of something of value to you is only theoretical unless and until this happens.

• Con: No money is sent to you. If you want the money represented by the increased value, you must sell some of your shares. The money you receive from the sale is then taxed at either the long-term or short-term capital gains rate (assuming that the sale is at a higher price than you originally paid for the shares). The federal long-term rate is 15%, the same as with dividends. The short-term rate is your marginal tax rate, which is probably higher.

• Con: Share repurchase programs are “one-offs,” not regular programs at most corporations. They are not predictable as to size or frequency.

• Con: Share repurchase programs are not monitored closely. Many of them are never completed after their initial announcement. Such failures are inconsistently reported in the financial press.

• Con: Many companies repurchase shares in order to pay off their executives (and other employees) on stock option grants. The executives turn around and sell the shares back to the company immediately, because they are part of their compensation package. Thus, the company's share buybacks are a compensation expense to the company. The executives, not the owners, are getting the money.

• Con: Often, share repurchases are made when the stock’s price is highest. That is because the program might be implemented in response to a burst in profits, which drove the share price higher in the market. It might also be because the company needs the shares now to pay off options which are being exercised—the timing of which the company cannot control.

It is an unfortunate fact that, at many companies, management acts in a fashion which benefits itself more than shareholders—even though the shareholders are the owners of the firm. Why does this happen? In a large, widely-held company, the Board of Directors—whose fiduciary duty it is to protect the long-term interests of the shareholders—is really a captive of management. Management proposes, and the Board rubber-stamps, ineffectively executing its oversight function. That’s what is at the bottom of so many of the corporate scandals of the past decade.

Contrast this with a privately-held firm. Some of these firms can be quite large, but their ownership is not very dispersed compared with that of a publicly held company. At such a firm, the company runs things for the benefit of its owners—who often sit on the Board. The Board is not captive of management, management is a captive of the Board—which is as it should be. At such firms, you better believe that high dividend payouts are part of the deal for the owners. Dividends rank well ahead of buybacks as claims on corporate profits. Whatever earnings are not required to fund current operations or expansion are funneled directly to the owners. If you were the sole owner of a company, isn’t that what you would do?

So, if one of your investment goals is current income, it should be obvious by now that dividends are far more desirable than share repurchases. They come regularly (and are often increased); they come in the form of cash, which is income immediately; they are taxed at a low rate; and they do not require you to sell shares in order to realize the “something of value” being passed on to you. Furthermore, the fact that management maintains a strong dividend program suggests that the company is being run for the well-being of its owners, not for management. Management is probably making smarter decisions with the retained earnings it has left (after dividends are paid), which can only benefit you as a long-term shareholder.

If you would like to learn about a stock investment approach that that uses the same strategies reflected in this article, including how to identify reasonably priced dividend-paying stocks, please consider purchasing "Sensible Stock Investing: How to Pick, Value, and Manage Stocks."

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