This Could Be Better Than Earning Dividends

Investors in dividend stocks love to find companies that generate a lot of cash, since all that money can help support and grow dividend payments over time. Yet while no one can dispute the appeal of earning dividends from your investments, investors should still assess whether companies that use dividends to return money to shareholders are actually using their spare cash in the best possible way.

The age-old dilemma
Historically, companies that have more cash than they need for their business operations have had a couple of choices. One option is to pay money directly to shareholders through dividends. Another is to buy back shares of their stock in the open market.

Your first thought might be that as a long-term investor, you'd much prefer to get a dividend, because you'd prefer to keep your shares and get some cash rather than selling them back to the company. But at least in theory, the impact should be the same.

Consider a simple example: A company with 100 shares outstanding that's trading at $10 per share has $100 in extra cash. It can either pay a $1 dividend or buy back 10 shares. If it pays the dividend, investors get $1 per share, but since the company paid out $100, the after-dividend company should be worth $100 less or $1 per share. Similarly, if the company buys back 10 shares, it still has 90 shares remaining, but the price per share should rise to reflect few outstanding shares. Both situations yield the same ultimate results for the company.

Are buybacks smarter?
In fact, from a tax perspective, investors should actually prefer buybacks. Dividends are immediately taxable when you receive them. But to the extent that buybacks support share prices, they create capital gains that you only pay tax on when you sell your shares. Moreover, if the current low tax rate on dividend income disappears in the coming years, it would make buybacks that much more attractive.

Critics, though, point to some valid concerns over buybacks. The biggest is that if companies aren't careful about when they buy back shares, they can end up making what in effect is a very bad investment. For instance, take a look at some of the companies that were making big buybacks two years ago near the market top:

Source: Standard and Poor's, Yahoo! Finance.

In contrast, relatively little buyback activity occurred earlier this year when share prices were depressed. Moreover, several of the companies that did so, including Amgen and McDonald's, actually held up well, so their shares weren't nearly as much of a bargain as companies that fared worse in the economic downturn of the last year.

That's not to say there aren't exceptions. Perhaps the best is Wynn Resorts, which did a secondary offering of shares in October 2007 at $154 per share and announced a buyback the following July, after shares had plummeted below $70. All too often, though, companies spend money on buybacks during good economic times, when their shares tend to be priced more richly.

Hiding options
The other concern behind buybacks is that they're often used to fight against the dilution caused by employee stock options. If a company buys back shares at full market value and subsequently issues the same number of shares on the cheap to executives through options, then the company is essentially transferring the difference from current shareholders to company executives. Of course, options have that impact regardless, but buybacks mask the dilutive effect that options have.

The best way to view buybacks is from the perspective of any investor choosing whether to buy a stock. If shares are attractively priced, then buybacks can be a smart way for companies to use their money. If they're overvalued, though, shareholders would be much better off getting a dividend and spending the money on more attractive investments.

Todd Wenning has scoured the stock exchanges for the best dividend stocks. Check out his top 7 great American stocks on sale.