In tonight's report, I'm going to more closely examine the two primary ways in which corporations can return money to their shareholders: dividends and share repurchases.

First, though, let's take a look at how one of the tools from the Rule Maker bag of tricks helps us measure the amount of cash available for shareholders -- the Cash King Margin (CKM). The numerator of the CKM is calculated by pulling a couple of numbers from the cash flow statement. We start with "cash provided by operating activities" and then adjust for net "additions to property and equipment." That leaves us with free cash flow (FCF). We then divide FCF by total revenue to determine the CKM. The formula looks like this:

(Operating Cash Flow - Capital Expenditures)
So how does this relate to dividends and share repurchases, you ask? Well, a company's free cash flow is what is used to pay its shareholders in the form of either dividends or stock buybacks. In general terms, dividends and/or share repurchases are the default use of cash when there are no better investment alternatives. Cash sitting idly on a profitable company's balance sheet will actually reduce profitability ratios such as return on assets and return on invested capital. The general rule is that if a company does not have a way to invest its money that will provide a sufficient return to its shareholders it should return that cash to its shareholders so that they can invest it themselves.

In some cases, companies will buy back stock by borrowing money. This can be done to change the relative allocation of debt and equity on the company's balance sheet. Since interest expense is tax deductible, there are companies that favor carrying some debt on their balance sheet due to the fact that it's cheaper to finance via debt than equity (For more on this topic, see "Debt: The Good, the Bad, and the UGLY -- Part 1 and Part 2").

Let's take a look at Intel's (Nasdaq: INTC) Q1 '00 cash flow statement and use it as an example so that we can put our numbers in context. Here are the key numbers we need to calculate Intel's free cash flow for the first quarter:

  $3,281  --> Net cash provided by operating activity   
 - 1,074  --> Addition to property, plant & equipment      
= $2,207M --> Free Cash Flow                           

As you can see, Intel's first quarter free cash flow rang in at $2,207 million. Not bad for a quarter's work! Since Intel's sales for this period were $7,993 million, that transates into a Cash King Margin of 27.6% (2,207 / 7,993). That's a solid performance, and well ahead of our 10% benchmark minimum.

Another way of looking at this is that 27.6% of Intel's first quarter revenue could have been returned to shareholders. If we take another gander at the cash flow statement, we can see how much of that cash Intel actually returned to its shareholders. The answer is found in the section of the cash flow statement called "cash flows provided by (used for) financing activities." During the quarter, Intel used about 45% of its free cash flow -- an even $1,000 million -- to repurchase stock. But, it only used about 4.5% of its free cash -- $100 million -- to pay dividends to its shareholders.

Based on these figures (or those for just about any other period that you can check), it's pretty clear that Intel has favored buying back stock to paying dividends. If you're an Intel shareholder, you may or may not appreciate the way that Intel allocates its free cash flow.

To understand why Intel favors share buybacks, it may help to review the basics about how shareholders are taxed on buybacks compared to dividends. Dividends are ordinary income. That means that you, the shareholder, pay tax on any dividends that you receive based upon your marginal tax rate (the maximum individual tax rate is currently 39.6%). You have no choice as to whether or not you pay this tax. If Intel decides to pay a dividend, you pay tax on it. There are clearly some disadvantages to that arrangement.

If Intel decides to repurchase its own shares and you want to participate in the buyback, you have two options. One is that you can sell some of your shares. If you do, and you have held the shares for longer than a year, you pay tax at the long-term capital gains rate (the maximum rate for individuals is currently 20%). If you decide not to take a portion of the money that Intel is returning to its shareholders, then you don't pay any tax at the time of the buyback at all. Clearly, from a tax perspective this gives you more flexibility than you have with dividends.

I just talked about changes in your share ownership as a result of share buybacks. Let's take a look at how that comes about. To the extent that a company buys back shares, the number of total shares outstanding decreases. That means that your ownership interest in the company marginally increases each time there is a share buyback. Confused? Don't be! Here's a simple example:

Say that you own 100 shares of Verve Inc. (Ticker: MATT), and that there are 1 million total shares outstanding at $20 each (total market cap = $20 million). You own 0.01% of the company. Next say that Verve decides to buy back 50,000 shares. Since you're a long-term investor, you decide to hold on to your shares. At the completion of the buyback, your ownership interest has increased to 0.01052%. All other things being equal, the value of each share would now be $21.05, in order to keep the market cap of the company at $20 million. By utilizing a share buyback, Verve delivered per-share value of $1.05 without any negative tax ramifications. By way of comparison, if Verve had issued a $1.05 per-share dividend, you would only receive $0.65 or so after taxes.

Does this mean that dividends are always bad? While I prefer share buybacks, I don't object to dividends such as the $0.16 per-share annual dividend that Intel pays. There are two reasons for this. One is that the payment of this small dividend enables Intel to offer a very shareholder-friendly dividend reinvestment plan (DRIP). Speaking of DRIPs, you may know that Intel is a major holding over in the Drip Portfolio. (If you're interested, here's a list of other Rule Maker DRIPs.)

Also in the defense of dividends, if you don't have a current need for your cash dividends and if your broker allows it, you can reinvest your dividends. This may allow you to make incremental investments in the stocks over time and at no cost.

If you think that investing such dividends is meaningless, I can offer up an example as to why you might want to reexamine that conclusion. I have an account where I've been reinvesting all the Intel dividends that I've received. (I first purchased shares in May 1995.) The first dividend that I earned was paid to me in June of that year, also at a rate of $0.16 per share annually (which is now $0.64 after taking into account the impact of the two two-for-one stock splits that have occurred since that time). Those reinvested dividends have increased 7-fold during the time that I've owned them. That's clearly a better return than I would have gotten by putting the dividends in a bank account.

Personally, I don't mind small dividends at all in those cases where they enable the company to set up an investor-friendly DRIP. Where possible, I also favor reinvesting any such dividends in additional shares of stock. But, all in all, due to the flexibility that they provide to shareholders from a tax perspective, I prefer share buybacks to dividends.

If you wish to discuss this report further, please feel free to ask your questions on either the Rule Maker Strategy or Rule Maker Beginners boards.

And finally, there's only ten days left to sign up for the upcoming Rule Maker Seminar. Whether you're a rookie or a veteran to this way of investing, it's going to be a fun and informative experience. We'll be explaining the strategy step-by-step, while also going deep into examples from our focus group of companies (which you chose). And of course, you'll be choosing our next investment by seminar's end. For more details, check out our RM Seminar Information Page.

Phil Weiss (TMFGrape on the boards)