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Successful companies have an enviable decision they have to make: what to do with their profits. Increasingly, investors have sought companies that use that money to pay healthy dividends to shareholders. But is there a better way for investors to get even more value out of corporate profits than they get from just taking cold hard cash?
A new study from Merrill Lynch takes a new look at an old answer to that question: share buybacks. Once seen as the only smart way to handle extra cash, buybacks have fallen out of favor as investors don't trust corporate executives to make the right decisions with their money. Now that dividends are the more popular alternative, Merrill's research points back in the other direction.
Buybacks vs. dividends
Theoretically, it should make no difference whether a company pays a dividend or implements a buyback. Consider: If a company pays a dividend, then the assets of the company drop by the amount of cash it has to pay out, leaving shareholder equity unchanged. Similarly, when a company buys back shares, it reduces its total share count outstanding, but it also proportionally reduces the value of its remaining assets -- again leaving continuing shareholders in the same position they were in before the buyback.
However, theory doesn't work in practice. When companies announce buybacks, shares typically jump in response. And what Merrill found is that companies that buyback shares outperform dividend-paying stocks by more than 2 percentage points on average -- as long as the buybacks happened when valuations on stocks were low.
It's vital to include that low-valuation caveat. Historically, many companies have made terrible decisions in timing their share buybacks. Going back to 2007, General Electric (NYSE: GE ) , Cisco Systems (Nasdaq: CSCO ) , and AT&T (NYSE: T ) were just a few companies that spent $10 billion or more buying back shares. As it turned out, those "investments" were made right at the market top, and each of those stocks lost between 25% and 60% over the ensuing two years.
In contrast, many companies cut back or even eliminated buyback programs during the financial crisis. It's easy to understand that when money was tight, it would make sense to hang onto it within corporations rather than return it to investors -- but that was the time when buying back shares would have produced the best returns for that money.
Only after the huge recovery rally did companies jump back on the buyback bandwagon. Coach (NYSE: COH ) , for instance, nearly quadrupled in price from January 2009 to January 2011 before announcing a $1.5 billion buyback. Intel (Nasdaq: INTC ) joined the $10 billion buyback club earlier this year, but only after shares had jumped an average of 30% annually over the past two years.
Take the money and run
The implication of the Merrill report is that for companies that truly offer bargains, buybacks might make more sense than paying dividends. For instance, at multiples of less than 10, Microsoft (Nasdaq: MSFT ) and Hewlett-Packard (NYSE: HPQ ) might be good examples of undervalued stocks where a buyback would do more good than a dividend. In addition, buybacks also keep shareholders from having to pay taxes on dividends they receive, while arguably providing the same value enhancement.
But the most compelling reason why dividend stocks are here to stay is that with income from other investments so scarce right now, getting income from dividends is about the only choice left for many investors. Smart companies will capitalize on that trend to take advantage of investor demand for their shares while the getting is good. That's reason enough to stick with dividends for a big part of your portfolio.
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