When a publicly traded business is ready to reward its owners -- namely, you, the shareholders -- with a taste of the profits, nothing satisfies like a dividend. Companies that pay out a portion of their earnings, like those recommended in the Motley Fool Income Investor newsletter, are generally sound, mature businesses with proven past profitability and a reasonable expectation of solid future performance. These businesses make good long-term holdings, and in my opinion, they should serve as the foundation of a well-diversified stock portfolio.
Once a company is ready to distribute its excess cash flow, it can either pay a dividend or buy back shares on the open market. The former puts cash in the pockets of investors; the latter increases their ownership stake. While share buybacks offer the promise of a satisfying financial meal at some unspecified time in the future, dividends offer more instant gratification. While both dividends and buybacks benefit investors, there are a few key reasons why I prefer the cash payout.
Dividends focus management on operations
When CEOs know that investors expect a regular payout, they tend to be more prudent in deciding the future course of the business. Speculative investments that will drain cash without necessarily adding to earnings look less enticing. Price discipline also becomes more critical, and using stock for acquisitions less appealing, since the latter move would increase shares outstanding. The focus instead turns away from growth at any cost and toward efficient operations, with the aim of sharing some of the profits from operations with shareholders.
Dividends are share-price neutral
As corporate fortunes wax and wane en route to what investors hope will be solid long-term gains, dividend payouts can be a stabilizing factor. Even the best investments' share prices can behave like a roller coaster. Dividend payouts at a fixed or preferably growing dollar value per share offer some steady compensation throughout the turmoil.
For shareholders reinvesting those dividends, stock price fluctuations offer the benefits of dollar-cost averaging, letting them buy more shares when the price is low. In his book The Future for Investors: Why the Tried and the True Triumph over the Bold and the New, author and Wharton School professor Jeremy Siegel makes just such a case for the power of long-term dividend reinvestment strategies. His research demonstrates that a program of dividend reinvestment contributed to the near half-century of stellar performance turned in by companies like Altria
Individuals relying on the income derived from dividends can largely ignore those price fluctuations, so long as future payouts appear secure. They also benefit from the stock without needing to sell shares -- and incur transaction fees -- to get cash from their portfolios
Stock buybacks, however, are not price-neutral. Repurchasing company stock near the top of a price cycle is a poor investment, and thus a poor use of cash. Companies flush with funds due to one-time or unsustainable business operations would be better-served paying a one-time dividend than buying their own stock at what may be a temporarily high price. Of course, repurchasing stock when the share price represents a good value is a far better investment. Share buybacks thus require management to "manage" the price of its stock.
Dividends encourage insider ownership
When a company's management itself has a significant financial interest, shareholders tend to benefit as well. Stock-owning management derives a current financial benefit from dividends by receiving a cash payout for its stake in the business. Paying dividends should therefore be a win-win for both management and investors.
However, the 1990s trend toward stock-option grants as part of management compensation has encouraged companies to favor stock repurchase programs. Buybacks became necessary to avoid excessive dilution when management exercised stock options. Option-owning managers derive no substantial benefit from their company's dividend payments, while share buybacks increase the ownership stake of their unvested future options. Large option grants also put managers in the perverse position of wanting to exercise their stock options when the share price is high, but buy back shares when the price is low. That's an incentive to attempt to manipulate, rather than manage, a company's share price. Dividend-stock-owning management has no such conundrum; it simply needs to concern itself with operations in order to ensure the sustainability of the dividend stream.
Stock buybacks may offer some future promise of shareholder benefit, but only when done prudently. Cash payouts, in the form of dividends, do reward shareholders, and they do it now. Dividends favor current shareholders; buybacks favor future shareholders, including option holders. In addition, the tax consequences for long-term capital gains and qualified dividends are similar for most investors.
Investing is generally fraught with future promise. Dividends can be an island of stability in a turbulent market, helping investors achieve long-term outsized gains.
Fool contributor Ralph Casale loves those tasty payouts, and he doesn't ever recall seeing a dividend "restated." He owns shares of Abbott Laboratories, but holds no financial position in any of the other firms mentioned. The Motley Fool has a disclosure policy.