Cash Dividends vs. Share Repurchases
Which is Better for Your Portfolio?
John D. Rockefeller, the world’s first billionaire, once remarked that nothing gave him more pleasure than to see his dividends come into headquarters. In the five-part article All About Dividends, we provide an overview of the different types of dividends – cash, property, etc. – and the meaning of important dates such as the Ex-Dividend date. Questions remain, however; should a company pay its shareholders dividends?
Should intelligent investors insist only on purchasing shares of businesses that have a consistent record of steady dividend increases or is it better for a company to plow all of its earnings back into the company for expansion? Relax! We’re going to take a look at these issues and more, empowering you to help take control of your portfolio.
Historical Shift Away from Cash Dividends
Throughout the history of organized capital markets, investors as a whole seemed to believe that companies existed solely for the sake of generating dividends for the owners. After all, investing is the process of laying out money today so that it will generate more money for you and your family in the future; growth in the business means nothing unless it results in changes in your lifestyle either in the form of nicer material goods or financial independence. Certainly, there was the odd exception – Andrew Carnegie, for example, often pushed his Board of Directors to keep dividend payouts low, instead of reinvesting capital into property, plant, equipment, and personnel.
Some high profile privately owned family firms have had near cataclysmic schisms over the dividend policy. Often you have those involved in the day to day operation of the business on the one hand who want to see the money go into funding growth, and on the other, those who simply want larger checks to show up in the mail.
In recent decades, a fundamental shift away from dividends has developed. Partly responsible is the U.S. tax code, which charges an additional 15% tax on dividends paid out to shareholders (before the Bush administration, this tax was as high as the graduated income tax – in some cases exceeding 35% on the federal level alone). Combined with the enactment of rule 10b-18, passed by Congress in 1982, protecting companies from litigation for the first time, widespread repurchases could be undertaken without fear of legal consequences. As a result, many high profile Board of Directors made the decision to return excess capital to shareholders by repurchasing stock and destroying it, resulting in fewer shares outstanding and giving each remaining share a larger percentage ownership in the business. Consider that in 1969, the dividend payout ratio for all companies in the United States was 55%. In April 2000, the S&P 500 dividend payout ratio hit an all-time low of 25.3%, according to the newly revised edition of The Intelligent Investor. More recent statistics tell an even clearer story: According to Standard and Poor’s, in fiscal 2005, the S&P 500 generated net income of $634 billion and paid cash dividends of $201.84 billion on a market value of approximately $11 trillion.
One estimate by Legg Mason shows that share repurchases for the year approximated an additional $250 billion, resulting in a total return to shareholders of roughly $451 billion, or 71% of earnings.
Two Major Advantages to Share Repurchases
Share repurchases are a more tax efficient way to return capital to shareholders because there is no additional tax on buybacks even though your pro-rata equity in the enterprise increases, resulting in potentially more profit and cash dividends on your shares even if overall sales or profits never increase. However, there is one problem that can undermine these results, rending repurchases far less valuable:
- If the share repurchases are completed when a company’s stock is overvalued, shareholders are harmed. It is, in effect, the same as trading in $1 bills for $0.75, destroying value.
- If large stock options or equity grants are issued to employees and management, the repurchases will, at best, neutralize their negative impact on diluted earnings per share. The actual number of shares outstanding won’t decrease. In this case, the share repurchases are merely a clever guise for transferring money from the shareholders to management.
Three Major Advantages to Cash Dividends
There are three major advantages to cash dividends that simply aren’t available through share repurchases. They are:
- Psychologically, cash dividends can be enormously beneficial for a shareholder. Imagine, for a moment, a retired school teacher living in a house in the suburbs with a portfolio of $500,000. If she were invested entirely in companies that retained all of their capital and/or repurchased stock, a major market drop of 20%, creating a paper loss, might concern her (it shouldn’t necessarily – for more information read How To Think About Share Prices). If she were to invest in income producing equities with an average dividend yield of, say, 4%, the same loss probably wouldn’t bother her because she would be consoled by the $20,000 cash dividends that arrived in the mail each year. In other words, the distribution of the profit will cause her, knowingly or not, to act more like a business woman acquiring a stake in a private enterprise than a bystander subject to the whims of the stock market. With cold, liquid greenbacks in her hand, she can pay her bills while waiting out the temporary insanity of Mr. Market.
- The need to constantly keep enough cash around each quarter to distribute dividends to stockholders tends to require companies to maintain more conservative capitalization structures, subtly reminding management that they are there to produce wealth for the owners of the business – not just make their empire bigger. It also tends to prevent large cash hoards building up that are inevitably blown by an adrenaline-filled CEO feeling pressure from Wall Street to “do something.” Typically, it seems as if the action of choice is to consummate an expensive acquisition, destroying shareholder value.
- All else being equal, firms that pay cash dividends will not experience as great a percentage decline in bear markets because the dividend yield acts as a protective cushion. Typically, if a well-financed, conservatively run business falls so that the dividend is yielding 15%, Wall Street is going to recognize the bargain and snap up the shares. If the cash remained on the balance sheet, investors seem more hesitant to swoop in and take advantage of the situation because there is not guarantee management will allocate the capital wisely.
The Final Verdict on Cash Dividends vs. Share Repurchases
What is the final answer: which is better, cash dividends or share repurchases? Like so many questions, the answer is simply, “it depends.” If you are an investor that needs cash upon which to live or want to ensure that you, rather than management, can allocate excess profit, you might prefer dividends. If on the other hand, you are interested in finding a company that you truly believe can generate large profits by reinvesting in a business that can earn high returns on equity with little on debt, you may want a firm that repurchases shares. Be careful, though, and realize that at the end of the day a company can be extraordinarily successful if the other things are in place, regardless of the total share count. Starbucks, for example, has experienced significant increases in shares outstanding during the time it has been a publicly traded company. These shares have motivated employees to help build the business and resulted in tremendous profitability and growth for the company’s initial investors. Wal-Mart, on the other hand, has maintained (split adjusted) a fairly steady share count and in recent years has decreased the number of shares outstanding while experiencing high growth and paying cash dividends – it stands alone as one of the perfect combinations in Wall Street history.
Most likely, a hybrid model will be preferred by directors, such as Home Depot; the home improvement chain has returned over 65% of profits to shareholders in recent years through a combination of aggressive share repurchases and cash dividends. At the same time, it’s increasing its store base and acquiring businesses on the supply side of the industry.