In a recent series of blog posts, noted NYU professor of finance and valuation expert Aswath Damodaran has fleshed out some of his thoughts on the shift from dividends to buybacks over the past couple of decades, pointing out the reasons for the shift and the relative pros and cons of each method of returning cash to shareholders. Each post is worth a read (as is the rest of his work), but of particular note is his idea of an "augmented dividend": calculating the yield on a stock by combining dividends and stock buybacks.
Dividend cloaking systems engaged
What makes the idea of augmented dividends especially interesting -- aside from the fact that it sounds like something from science fiction -- is that it can turn a non-dividend-paying stock into a high-yielding one. A buyback yield can be found by dividing the amount a company spends on buybacks by its market capitalization. (Since buybacks tend to vary wildly in size, it helps to average them by adding up the trailing 12 months of buybacks and dividing that into the market cap at the time.) Here are some stocks with high buyback yields over the last year:
TTM Net Buybacks
|AutoZone (NYSE: AZO )||$1,148||$11,329||10.1%|
|Papa John's International (Nasdaq: PZZA )||$61||$756||8.1%|
|Cisco Systems (Nasdaq: CSCO )||$5,678||$122,217||4.6%|
|Boston Beer (NYSE: SAM )||$50||$1,255||4.0%|
Source: Capital IQ, a division of Standard & Poor's. Amounts in millions.
The same exercise can be done for dividend-yielding stocks, simply by adding the buyback yield to the dividend yield. For example, on the surface, Hasbro (Nasdaq: HAS ) has a dividend yield of about 2%, but its regular buybacks give it an augmented yield of 12%.
Dividend decloaking off the port bow
The counterargument, of course, is that a dividend represents actual cash in a shareholder's pocket, whereas buybacks only serve to create capital gains by increasing earnings per share, and, consequently, the stock price. This is a far less certain proposition. And as Damodaran points out, even though a buyback may increase EPS, it should theoretically also increase the discount rate, a measure of risk inherent in the stock, lowering the stock's valuation back to the same price. This is because the cash, which was more or less riskless, has now been converted to shares, which carry much more risk even for a relatively stable stock.
That said, the market is rarely so perfectly efficient. As investors, we are constantly looking for undervalued stocks, and it would be lowercase "f" foolish to think managers don't sometimes realize their company's stock is undervalued and repurchase shares at the right time, creating value for shareholders and sending the market a signal at the same time.
Indeed, while most buybacks are done on the open market, occasionally managers are so bullish on their own stock that they use a fixed-price tender offer, offering to buy a certain number of shares at a premium to the current market price. Shareholders who sell their shares to the company in such situations do get to see actual cash in their pockets.
Last July, Fidelity National Information Services (NYSE: FIS ) announced it would repurchase up to $2.5 billion of its own shares at a price ranging from $29 to $31 per share, a 7% to 14% premium to the stock's closing price that day. Investors who sold their shares to the company received the equivalent of a hefty dividend, and those who held their shares have seen the price rise that same 14%.
Leave no stone unturned
Even though buybacks have been getting a lot of attention lately, they still lack the august position of traditional dividends. And in many ways, dividends are still superior, as they tend to be more regular. One of the ironies of buybacks being a kind of hidden dividend is that it's easier for managers to stop them during hard times, because fewer people are paying attention. But when fewer investors are paying attention, the ones who are can often find some great hidden values.
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