Investing in dividend stocks has never been more popular, and it's not hard to figure out why. Between the large group of investors who actually need to draw income from their investment portfolios right now and the numerous other investors who prefer the security and stability that a solid history of paying dividends provides, dividend-paying stocks stand out from the crowd.
But not everyone thinks that paying dividends is the best move a company can make. In fact, many analysts believe that dividends are just plain dumb, and they're convinced that an alternate way of paying capital back to shareholders makes far more sense. That alternative is buying back stock to reduce a company's outstanding share float, and at least from a theoretical level, the idea carries a lot of weight.
The endless debate about dividends vs. buybacks
Capital allocation is an important part of managing a corporation, even if by all accounts, it should have little or no impact on the value of a company's stock. Consider two scenarios: one in which a company pays a dividend, and the other in which it buys back its own shares. With the dividend, the company distributes cash that immediately reduces the value of its assets by the same amount. Theoretically, the dividend payout should produce a dollar-for-dollar reduction in the value of the company, and therefore investors should end up breaking even.
Similarly, with share buybacks, each transaction reduces the number of outstanding shares, making any investor's particular shares represent a larger stake in the overall company. But again, the company's asset base shrinks by the cash the company uses to buy the stock, and those two effects should cancel each other out.
The problem, though, is taxation. When you receive a dividend in a regular account (as opposed to a tax-sheltered account like an IRA), you have to pay taxes on it. Even though qualified dividends are eligible for a lower top rate of 15% at the moment, it still represents a measure of double taxation.
By contrast, with share buybacks, the only investors paying taxes are those who sell their shares to the company. Continuing shareholders have no tax consequences whatsoever when buybacks happen.
Who's doing it?
Just because dividends have become exceedingly popular shouldn't convince you that buybacks have stopped happening. As a recent articles in Forbes discussed, Dow components Intel (Nasdaq: INTC ) and IBM (NYSE: IBM ) are among the companies that spend the most money on buybacks in order to keep their outstanding share counts down. Both companies have managed to reduce share counts by roughly 15% in the past five years, which has been a big contributor to improving earnings per share.
But those companies aren't close to the top of the list in terms of how much they've reduced their outstanding shares. Seagate Technology (Nasdaq: STX ) and Best Buy (NYSE: BBY ) , for instance, have aggressively bought back their stock and cut share counts by more than 25% each, even if their businesses are going in two completely different directions. DIRECTV has managed to cut its counts almost in half.
The flip side of the buyback argument is that companies often make bad decisions about when to buy back shares. Typically, companies have the most cash when they're doing well, and that happens to correspond with when their stock prices are the highest. As a result, they often buy high.
Even more important, companies always telegraph their buyback intentions, and share prices often rise in response. That immediately costs the company money, as it has to spend more to buy shares back.
It's because of these drawbacks that many investors prefer dividends. By holding dividend stocks in tax-favored accounts, you can avoid the double-taxation question, at least for a while. And more important, with dividend money, you're in control of how you reinvest the dividends you receive.
Don't let the tax tail wag the dog
Taxes are an important consideration in investing, but they're not the only consideration. Dividend-paying companies may end up forcing investors to incur taxes that are theoretically unnecessary, but the peace of mind that many investors get is well worth that cost. That makes those companies just plain smart in my book.
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