Dividends Versus Share Buybacks

Posted by Jeff Carter
on July 23rd, 2010

This is a controversial topic these days in corporate finance. Corporations are accumulating cash on their balance sheets. Why would a company deliberately accumulate cash? Carrying excess cash can put a target on a company’s back. They become a target for takeover.

-They cut costs, sales are either up or level and they recognize more revenue from operations.
-They are hoarding cash with expectation that economic conditions will be tougher in the future, especially given the massive tax hike companies will get on January 1, 2011.
-They don’t have any internal company projects that are net present value positive to spend it on
-They don’t see any potential acquisition targets that appeal to them.
-Pay down any outstanding debt. However, many companies want some debt because of the tax advantages of debt.

In a nutshell, these are the options available to the typical Chief Financial Officer(CFO). When they exhaust these options, they are left with two more.

-pay a dividend to the holders of preferred or common shares
-buyback stock

Each action has opportunity costs.

Paying a dividend to investors might create tax problems for the investors. Many investors prefer NOT to get a dividend, and would rather make money via the capital appreciation of the stock. Many mutual funds prefer not to get dividends, and make their voice heard in no uncertain terms. The US government also has a backward tax policy, so dividends get taxed twice. Once when the company earns the money, and second when the investor gets the proceeds. It’s a really dumb policy that should be changed.

Buying back stock does nothing for the long term holders of the shares. It only rewards speculators, option holders who want to sell (i.e. management) and short term swing traders. Buybacks don’t do anything to improve the financial position of the company. As a matter of fact, it is a way for management to try and mask poor performance by monkeying with PE ratios.

Research points to a few things. When a company engages in a buyback, generally their share price declines after the buyback. It’s not necessarily a bullish signal. A bullish signal is if management uses their own money to buy stock. Rest assured, if a top line manager is buying their own companies stock it’s going up.

Buybacks also benefit investment banking firms. This may be why they are the rage. Investment bankers act as brokers to the transaction, earn a fee from that. They also earn a fee for their advice, and a fee for structuring the buyback. Investment banks have a giant incentive to encourage buybacks rather than dividends.

Dividends on the other hand actually are good for investors despite the tax consequences. The investor that reinvests their dividends rather than accept a check does better over the long haul than investors that do with buybacks. Dividends also tangibly increase total return on a stock-buybacks don’t. Dividends are cheap for a company to administer, buybacks are not. Traditionally, distributed dividends point to the health of a company-buybacks don’t.

In my opinion, stock buybacks are generally bad for investors.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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