Dividends or Buybacks? The Story of How to Waste Shareholder Money

Last week, I somewhat skewered Google (NYSE: GOOG  ) , Microsoft (Nasdaq: MSFT  ) , Hewlett-Packard (NYSE: HPQ  ) , and Apple (Nasdaq: AAPL  ) for their dividend policies, which for all four are either nonexistent or inadequate. It's putting a damper on valuations, I reckoned.

Some readers fired back: Dividends might be small, but for at least a few of these companies, buybacks are big -- and that's rewarding shareholders in ways similar to dividends.

It's a fair point -- to a point. Some of these companies are providing real value through buybacks. Based on three-year average share buybacks, HP, for example, will repurchase its entire current market cap sometime within the next decade (based on current shares prices, of course). Things could turn disastrous, but in all likelihood these repurchases are a tremendous deal for shareholders.

But that isn't the norm. Buybacks are beneficial if done when shares are cheap. If they're done when pricey, well, it's scarcely different from when you or I overpay for stocks: You don't get your money's worth.

Can you guess which group most corporate managers fall into?

This chart, representing all S&P 500 companies, sums it up:

Sources: Standard & Poor's and Yahoo! Finance. Subsequent two-year return is the return of the S&P 500 as a whole.

The trend is clear: Managers repurchase the most amount of stock when shares are the most expensive, and abandon buybacks when shares are the cheapest. Buybacks exploded to record highs in 2007 when the market peaked, only to nearly cease when shares were at decade lows in 2009. Some individual examples are astounding. In late 2007, Citigroup (NYSE: C  ) struck an expensive deal with the Abu Dhabi Investment Authority to raise $7.5 billion in equity after shares plunged. Ironically, that was nearly the same amount Citi spend repurchasing its own shares over the previous two years at substantially higher prices. Hindsight is 20/20, but this was a colossal waste of money.

You could say these buyback swings are simply a matter of earnings swings. S&P 500 buybacks were high in 2007 because earnings were high; they stopped in 2009 because earnings evaporated. But this theory doesn't quite hold. Earnings are now at an all-time high, yet share buybacks are roughly half as much as they were in 2007.

Instead of repurchasing shares, what if managers had focused solely on dividends?

The drawback from shareholders' perspective is that dividends are taxed at up to 15%, while buybacks avoid the additional pass-through tax layer altogether.

But there are benefits. With dividends, those who wish to keep reinvesting in the company -- as share buybacks do -- can simply reinvest their proceeds. For companies with DRIPs, this doesn't get any easier. More importantly, those dividend reinvestments are up to you. Think shares are cheap? Reinvest your dividends. Think they're getting pricey, but you still don't want to sell the stock? Stop reinvesting and accrue cash dividends. The decision becomes yours, not management's. You may still fail -- but it's your failure, not theirs.

The question is whether preferring dividends over buybacks is worth the potential 15% haircut from dividend taxes. For some companies -- HP, for example -- it probably isn't. In general, though, it very well may be. Management is that bad at repurchasing shares. That's what the chart above emphasizes.

Are you happy with how management allocates capital? Let loose below.

Fool contributor Morgan Housel owns shares of Microsoft. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Google, Apple, and Microsoft. Motley Fool newsletter services have recommended buying shares of Apple, Google, and Microsoft. Motley Fool newsletter services have recommended creating a bull call spread position in Apple and a diagonal call 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. The Motley Fool has a disclosure policy.


Read/Post Comments (17) | Recommend This Article (25)

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 June 30, 2011, at 3:27 PM, crsecon wrote:

    Also buybacks waste corporate assets when purchasing shares to offset the increased number of shares from giveaway slush fund executive options. Market price of bought shares ALWAYS greatly exceeds the "value" on thecompany books of the options shares issued to insiders. Vote "AGAINST" options and bankster/directors who like them at proxy time.

  • Report this Comment On June 30, 2011, at 4:50 PM, ElCid16 wrote:

    What are the tax consequences of dividends vs. buybacks?

  • Report this Comment On June 30, 2011, at 6:09 PM, 11x wrote:

    truth, during that timeframe, how many stock options were awarded to PEP management? Some companies have been very effective at reducing their outstanding shares over long periods of time with long term buyback programs. MO is one example. PM will undoubtedly be an other. PGR and EV are two more. AZO as well.

    CSCO, meanwhile, bought it's shares back in the past but it did not reduce share count because they simply awarded the shares bought back as stock options.

    I'm a fan of share buybacks, but it has to be a long term strategy, not buying on a whim because things are great, and you have excess cash (this will most likely correspond with a high priced stock). So, in this case, I'm going to have to "betray my ignorance."

  • Report this Comment On June 30, 2011, at 6:24 PM, ElCid16 wrote:

    Truth,

    I know you aren't a big fan of DRIP plans, but many dividend investors are. For your average DRIP investor, buybacks are sort of a tax-free method of DRIP, right?

  • Report this Comment On June 30, 2011, at 7:26 PM, TimothyVR wrote:

    I will confess my ignorance here. I have absolutely no idea how share buybacks benefit investors.

  • Report this Comment On June 30, 2011, at 7:32 PM, TimothyVR wrote:

    Follow up to my above comment:

    I just found an article linked on my watchlist page from Smart Money about Vale. I own shares of Vale and I have watched it decline in recent months - I assume at least in part due to the Brazilian government mucking about with the position of CEO.

    Now they have approved a buyback plan for the coming months. This is supposed to be a benefit for share-holders. How will it benefit me? I don't see it. I would much rather see an increased dividend.

  • Report this Comment On June 30, 2011, at 8:19 PM, esxokm wrote:

    I personally enjoy dividends better than buybacks for the most part. Although, buybacks do have their place.

    Dividends represent real cash, and they help to create total-return value.

    I don't believe a company should use its stock currency for the purpose of employee compensation. A tight float should be the goal. Companies should use stock for acquisitions and other investments, but using it for employee compensation (especially for compensation of executives) doesn't make sense.

    Do people really work harder if they own options? Why not offer employees the ability to buy stock without the friction of commissions? And as for executives for which that would not be attractive (assuming they have the ability to buy large amounts of shares), one would assume they would buy shares of their own company if they believed the stock was a good investment even if they weren't given options. In theory, they would have an edge because of their position; would they refuse to exploit that edge because the company wasn't giving options away for free?

    As an aside, I'm always puzzled at the absence of a Disney mention in this kind of article. Disney to me should really pay a higher dividend. I wonder why it does not.

  • Report this Comment On June 30, 2011, at 9:16 PM, luger2 wrote:

    Presumably the sharecount would have been a lot higher without the buybacks assuming the options were already granted. Are the options not expensed and charged against earnings? Of course overgenerous options steal the shareholders money. I also don't believe they are much of a incentive to management to align their interests with shareholders. They should actually have to use some of their real earnings to buy shares on the open market just like other shareholders. That may align their interests with shareholders.

  • Report this Comment On July 01, 2011, at 12:56 AM, mhonarvar wrote:

    even with the 15% tax....its still money you get to see.

    Buybacks only increase value in theory....and only return money to you if you sell your stocks....

    Dividends are much better when done right, buybacks are always a shot in the dark.

  • Report this Comment On July 01, 2011, at 1:12 AM, Mstinterestinman wrote:

    I like both but it depends on the valuation of a companies stock.

  • Report this Comment On July 01, 2011, at 4:02 AM, daveandrae wrote:

    There are two sides to every story.

    Companies like IBM, Phillip Morris, Coca-Cola, Exxon Mobil, and McDonald's have been quietly shrinking their float AND raising their dividends for years and years with great success.

    Thus, in my opinion, it's not a matter of whether or not buybacks "work." The problem I see, after more than thirteen years of experience in this business is that excessive amounts of dilution clearly does NOT benefit the long term shareholder.

    If this were a parable, it would be similar to getting married. If you really picked the right spouse, then you know well in advance that through good times and bad, they live well within their means rather than diluting themselves with excessive amounts of debt.

    This does not guarantee that the marriage will be a "success". But it sure does make for one hell of a good starting point.

  • Report this Comment On July 01, 2011, at 6:59 AM, kgussion wrote:

    tHE THEORY OF IMPROVING THE P/E RATIO WITH BUYBACKS IS JUST THAT, A THEORY. IN ALL MY YEARS I'VE NEVER SEEN A PRICE INCREASE AS A RESULT OF BUYBACKS. GIVE ME THE DIVIDEND AND LET ME DECIDE WHAT TO DO WITH THE MONEY. AFTER ALL, I'M AN INVESTOR, BUT WITH NO REAL VOTE

  • Report this Comment On July 01, 2011, at 9:58 AM, pastreet wrote:

    I'll take the dividends... thank you.

  • Report this Comment On July 01, 2011, at 10:50 AM, sway28 wrote:

    Assuming a stock is near its "fair" valuation, share buybacks and dividends will have a very negligible impact on total shareholder return.

    The increase in net debt (due to cash outflow) will be offset by lower shares or dividend payment received.

    The real benefit of returning cash to shareholders is leveraging future returns. The increase in net debt as a result returning cash will increase future returns to shareholders. Simplistically, increasing enterprise value with few shareholders means higher returns for each shareholder and more cash generated per shareholder.

    Even if the stock is overvalued, are you really "destroying" shareholder value or not "maximizing" shareholder value? Depends on your alternative uses of cash.

    Clearly, a company would not want to buy back shares if their stock is unusually high. Hopefully , if a company is buying shares over time, buybacks will be dollar cost averaged, resulting in a short-term neutral impact to TSR.

  • Report this Comment On July 01, 2011, at 2:15 PM, Charbroil121 wrote:

    The impact of buybacks is obvious--free cash flow per share goes up. Since every investor wants to maximize the amount of free cash he/she is receiving per share, buybacks are an effective way of creating shareholder value--if the shares are inherent undervalued when purchased.

    Obviously, you don't want management paying too much for its own shares, just like you wouldn't want management paying too much on any other investment.

    By the way, your math is wrong about Pepsi up above--1.705B minus 1.605B is 100 million, not 1 million. Your math of ~$100/share is still right, assuming your share buyback dollar amount is right, but can you confirm that Pepsi spent 14B on buybacks over that time period, and that Pepsi didn't issue a large number of shares during that time period for some reason?

  • Report this Comment On July 01, 2011, at 4:04 PM, Canuck2010 wrote:

    For Canadian investors (and it appears that about 10% of Fools are in Canada) dividends are horrible. We get taxed at the full marginal rate (40-45% depending on the province) on US dividends. Capital gains get taxed at half that rate. Even worse is when the dividend drives down the stock price -- you end up with a capital loss and a heavily taxed dividend and less money than you put in.

  • Report this Comment On July 03, 2011, at 8:53 AM, FoolishMikee wrote:

    Three appropriate quotes before I go into my own thoughts:

    What works on Wall Street – James P. O’Shaughnessy

    "…shareholder yield. This concept requires a brief explanation. Companies have two basic ways to make payments to shareholders. The first is paying cash dividends as a distribution of their share of the company’s profits. But companies can also support their stock prices by buying up their own stock, thereby reducing the number of shares outstanding and shoring up the company’s stock price...this formula allows us to capture all of a company’s “payments” to shareholders, and it is indifferent as to whether those payments come in the form of dividends or buyback activity."

    Ken Fisher, in his book The Only Questions That Count wrote:

    "Here’s a good example of debt and corporate morality. Assume you’re CEO and you stock has a P/E of 16, which is an earnings yield…of 6.25 percent. Recall, that’s after-tax because the P/E was after-tax…If you can borrow at 4 percent after-tax and buy back your own stock, reducing available supply, you boost your earnings per share, capturing the 2.25 percent spread as profit – getting free money for your shareholders. It’s a no-lose trade as long as your earnings aren’t about to fall otherwise."

    “When companies borrow, the rate they pay is a pretax rate too, so the company with the P/E of 50 (E/P of 2 percent) can make its own earnings-per-share rise by simply selling stock at 2 percent and buying a 5 percent Treasury note and picking up the after-tax spread as profit. The firm with a P/E of 5 (E/P of 20 percent) can make its earnings-per-share rise by simply borrowing 10-year money at 7 percent (if that is what the going rate is) and buying back its own stock with a 20 percent after-tax return.”

    James O'Shaughnessy found that "Market Leaders, Shareholder Yield" beat "Market Leaders" and "Cornerstone Value" from 1952-2003. I won't go into explaining here, but in a nutshell, he found that "Market Leaders" with high shareholder yield beat "Market Leaders". Look up his much appraised book for more details.

    As for Ken Fisher, he would agree with the article, crsecon and many more of you that unless bought at a "fair" value, the company and shareholders are only then rewarded.

    I agree with esxokm that dividends represent cash and I would like to allocate my share of the company's profits in a way I best see fit. So whilst I'm not making a case against buybacks, I would like to see them well timed otherwise let shareholders decide.

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