A lot of people have been talking about the importance of dividends these days. There are only two ways a company can transfer value from the company to its shareholders. One is in dividends, which is cash payments per share at regular intervals. The second is share buybacks, which are announced by the company quarterly. Each company maintains a share repurchase program and announces updates to it on its quarterly conference call. So, which one is better? To answer that question, we must first define a few things.
Dividends & Dividend Yield
Dividends are the cash payouts per share of a given company, typically on a recurring schedule like quarterly. For example, if I look up Intel ($INTC) on Morningstar, I can see that it paid a $0.26 in dividends last quarter. Assuming that it kept the same dividend payment schedule for 2017, you could expect to make $1.04 per share of Intel in 2017 (four quarters).
To calculate dividend yield, you need to divide dividends by share price. In the Intel example above, if the dividends are $1.04 and the share price is $36.70 then the dividend yield would be 2.83%. Dividend yield is an important indicator in how well a company stock is doing and much of the S&P500’s total return is achieved through the index of companies’ dividends.
Share buybacks are a little trickier to manage and analyze. No data shows up easily in Yahoo! Finance that manages this metric like dividends and dividend yield. To evaluate its benefit to the shareholder, we must first understand how companies report earnings per share (EPS), which is the most widely used metric to evaluate a company and its stock. The spirit of the buyback is simple enough. If you reduce the total number of shares outstanding, then you directly improve the earnings per share, and that is all share buybacks do. They provide the ability to manage EPS a bit and provide the company with some financial engineering. If it can manage the total number of shares outstanding, then it can manage EPS.
How does an investor track a company’s share buyback program? Well, again it is not as straight-forward for share buybacks as it is for stock dividends. You need to look at the quarterly financial reports of each stock where it talks about its buyback program. If a company has 10,000,000 shares outstanding at $10/share and it is looking at a $10,000,000 share repurchase program, then it can remove 10% of its total outstanding shares. As an investor, you want to track how much is committed towards a share repurchase program. Ideal companies will have both a share buyback program and dividends.
Pros and Cons — Dividends
Here are the pros and cons of dividends. On the pros side, a company is giving a consistent cash revenue stream. Nothing beats returns in the form of cash payments. This stability is way above the hope and prayer of price appreciation of a stock. No one can depend on whether a stock’s price is going to go up or not, but they can depend on dividend payments.
Another pro is a company that consistently increases their dividend payments. These dividend-growing companies help ensure a healthy return because the companies earnings are good enough to support raising dividend payments. Stock prices typically go up too in proportion to the annual dividend increase amount.
Another pro for dividends is that a company is much more hesitant about removing or decreasing a dividend. Once it is in place, the market looks very unfavorably on companies that then reduce and remove their dividends. It means the company is not doing so well and investors take note.
The one main con of dividends is that the income is basically taxed twice. The earnings are taxed at a corporate level, currently around 35%. Once the company produces a dividend, those same earnings are taxed again in the form of an investor dividend, currently at roughly 15%. Taxing the profits twice is inefficient.
Pros and Cons — Buybacks
Here are the pros and cons of share buybacks. The main benefit of a share buyback program is its financial engineering impact and the ability to reduce outstanding shares, which allows a company to improve its earnings per share (EPS).
Another benefit is this method may begin a virtuous cycle. If the company consistently meets and beats its EPS targets each quarter, then the market may reward the company with a higher market multiple. A market multiple is how much an investor is willing to pay for a company’s earnings. If a company has a Price to Earning ratio of 15, then investors are willing to pay 15 times the company’s earnings for its stock. Many factors go into what a market is willing to pay for a company multiple, but consistent EPS and EPS growth, enhanced by a share buyback program, can create a better EPS and a higher multiple, both improving a company’s stock price.
The final benefit of share buybacks is that they are tax-efficient. The profits are not taxed twice because the buybacks are used to buy company shares.
The main drawback of a share buyback program is that it is not as structured; therefore, it is easier for a company to modify a share repurchase program. This fact means a company buyback program may change more than a similar dividend program. If profits see a downturn, a company’s share buyback program is one of the first things to be affected.
Both share buybacks and dividends are important factors to consider when evaluating a stock. More than just waiting and hoping for a stock to appreciate, these two methods are the main mechanics for a company to transfer value to its shareholders. I typically go for share buybacks because more growth companies use share repurchase programs to transfer value to their shareholders, and it is more tax-efficient than dividend payments, which get double-taxed. However, both are important. Since a big chunk of total return from an index like the S&P 500 comes from dividends, it is important to have good dividend-paying companies in your long-term portfolios.