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Is This Really Better Than Dividends?

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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.

Not overpaying
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.

Don't own dividend stocks yet? Get some great names from this free special report from The Motley Fool, which includes 13 dividend-paying stocks that deserve your consideration.

Fool contributor Dan Caplinger does dividends like nobody's business. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Coach, Intel, Cisco, and Microsoft; has bought calls on Intel; and has created a bull call spread position on Cisco. Motley Fool newsletter services have recommended buying shares of Microsoft, Cisco Systems, AT&T, Coach, and Intel; creating a diagonal call position in Intel; and creating a bull call spread position in Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. As you can plainly see, The Motley Fool's disclosure policy is the best around.

Read/Post Comments (6) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 17, 2011, at 6:14 PM, mikecart1 wrote:

    Dividends can be reinvested. Buy-backs can't. That is why mathematically your theory only hits the surface of what is going on. If MO did buy-backs instead of dividends, a shareholder would not come close to the performance of the last 20 years. With dividends, a shareholder's account would have exponentially rose over the last 2 decades. With buybacks, shareholders are left with far less.

    This is basic math 101. Yes dividends and buybacks both cost the company the same amount but reinvested dividends are far greater. Think of it like this, would you rather reinvest dividends or take the cash. So many examples show that reinvested dividends result in larger financial gains than just receiving cash.

    Come on Motley Fool! I'm taking ya'll to school! :D

  • Report this Comment On August 17, 2011, at 7:10 PM, lewellen180 wrote:

    I guess I look at it like this.

    If a company pays dividends, then you can choose to reinvest - which amounts to dollar-cost averaging. Over the long term, this should lower your average cost-per-share. Or, you can choose to take the dividends and invest them in some other company's stock, or in the broad market, or whatever. In either case, you're the one who makes the income allocation choice.

    The advantage to regular reinvesting is that it is dollar-cost averaging - it takes emotion and the requirement for many judgment calls out of the equation.

    If a company buys back shares, unless it does it with the same frequency and regularity as a dividend payment, then at each potential buyback somebody (not you) has to decide whether to make the purchase or not. This is not dollar-cost averaging by any stretch.

    So, besides the lack of choice the investor has when a buyback is performed instead of a dividend issued, it also loses all of the features traditionally associated with dollar-cost averaging - to wit, regularity and dispassion - that generate good performance.

  • Report this Comment On August 17, 2011, at 10:22 PM, mhonarvar wrote:

    With P/E ratios at many companies already at record lows....buybacks won't do much...

  • Report this Comment On August 18, 2011, at 12:26 AM, mm5525 wrote:

    Philip Morris International (PM) gives you both fat dividends and fat buybacks giving you the best of both worlds.

    PM raised their 2011 share buyback program to 5 billion dollars this year, up from 4 billion a year last year. In fact, by this year's close, PM will have bought back 17 billion dollars of their stock since spinoff from MO in March of 2008. When they first spun out of MO, they soon announced the 3-year $12-billion buyback program.

    PM also yields @3.78% and will raise their dividend by another @6 cents in September for the October payout just like they did last September.

  • Report this Comment On August 18, 2011, at 10:04 AM, pondee619 wrote:

    Does anyone report the "net" effect of these buy back programs? Stock bought back vs. stock issued? Are buy back programs really reducing the amount of stock outstanding?

  • Report this Comment On August 22, 2011, at 1:06 PM, smooth13 wrote:

    Dan, can you provide the link to the ML study?

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