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Dividends or Buybacks--Which Are Better for You?
by David Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
January, 2007
Both dividends and share buybacks are often cited as ways for a company to
“give back some 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 a portion of 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.
• 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 such 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 immediately, because they are part of their
compensation package. Thus, the shares are not taken out of circulation at all,
and other shares do not gain increased value as a larger piece of the pie. Share
buybacks do not return “something of value” to the shareholders at all, but they
are rather a compensation expense to the company. The executives, not the
owners, get 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. While some of these firms are quite
large, their ownership is concentrated compared with that of a publicly held
company. At such a firm, the company runs things for the benefit of its
owners—who often make up the majority of 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.
by David Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
January, 2007
Both dividends and share buybacks are often cited as ways for a company to
“give back some 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 a portion of 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.
• 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 such 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 immediately, because they are part of their
compensation package. Thus, the shares are not taken out of circulation at all,
and other shares do not gain increased value as a larger piece of the pie. Share
buybacks do not return “something of value” to the shareholders at all, but they
are rather a compensation expense to the company. The executives, not the
owners, get 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. While some of these firms are quite
large, their ownership is concentrated compared with that of a publicly held
company. At such a firm, the company runs things for the benefit of its
owners—who often make up the majority of 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.
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