Cash Dividends vs. Share Repurchases
Which is Better for Your Portfolio?
Should a company pay its shareholders dividends? Should smart investors insist only on purchasing shares of businesses that have a consistent record of steady dividend increases or is it better for a company to plow all of its earnings back into the company for expansion?
Historical Shift Away from Dividends
Throughout the history of capital markets, many investors have seemed to believe that companies existed solely for the sake of generating dividends for the owners. After all, investing is the process of laying out money today so that it will generate more money for you and your family in the future; growth in the business should result in changes in your lifestyle either in the form of nicer material goods or financial independence.
Certainly, there was the odd exception—Andrew Carnegie, for example, often pushed his Board of Directors to keep dividend payouts low, instead reinvesting capital into property, plant, equipment, and personnel. Some high-profile privately owned family firms have had dramatic schisms over the company's dividend policy. Often, those involved in the day-to-day operation of the business want to see the money go into funding growth, but investors simply want larger checks to show up in the mail.
In recent decades, a fundamental shift away from dividends has developed. Partly responsible is the U.S. tax code, which charges up to an additional 15% tax on qualified dividends paid out to shareholders (before the Bush administration, this tax was as high as the graduated income tax—in some cases exceeding 35% on the federal level alone). Combined with the enactment of Rule 10b-18, passed by Congress in 1982 and amended in late 2003, protecting companies from litigation for the first time, widespread repurchases could be undertaken without fear of legal consequences. As a result, several well-known boards made the decision to return excess capital to shareholders by repurchasing stock and destroying it, resulting in fewer shares outstanding and giving each remaining shareholder a larger percentage ownership in the business.
Consider that in 1969, the dividend payout ratio for all companies in the United States was around 55%. By 2013, the S&P 500 dividend payout ratio had slid to around 25%, near all-time lows. More recent statistics tell an even clearer story: The Standard & Poor’s 500 dividend yield stood at 2.11% on March 9, 2020, down from 7.44% at the end of 1950.
Since 1997, total share buybacks has exceeded cash dividends paid by U.S. firms, according to research conducted for S&P Dow Jones Indices.
The proportion of dividend-paying companies slid to about 40% by 2013 from 78% of companies in 1980, while the proportion of companies with share buybacks nearly doubled to 43% from 28% during the same period.
Advantages to Share Repurchases
Share repurchases are a more tax-efficient way to return capital to shareholders because there is no additional tax on buybacks, even though the shareholder's pro rata equity in the enterprise increases, resulting in potentially more profit and cash dividends on your shares, even if overall sales or profits never increase. However, there is one problem that can undermine these results, making repurchases far less valuable:
- If the share repurchases are completed when a company’s stock is overvalued, shareholders are harmed. It is, in effect, the same as trading in $1 bills for 75 cents, destroying value.
- If large stock options or equity grants are issued to employees and management, the repurchases will, at best, neutralize their negative impact on diluted earnings per share. The actual number of shares outstanding won’t decrease. In this case, the share repurchases are merely a guise for transferring money from the shareholders to management.
Advantages to Cash Dividends
There are three major advantages to cash dividends that simply aren’t available through share repurchases. They are:
The first is that, psychologically, cash dividends can be very beneficial for a shareholder. Imagine, for a moment, a retired schoolteacher living in the suburbs with a portfolio of $500,000. If she were invested entirely in companies that retained all of their capital and/or repurchased stock, a major market drop of 20%, creating a paper loss, might concern her. If she were to invest in income-producing equities with an average dividend yield of, say, 4%, the same loss probably wouldn’t bother her because she would be consoled by the $20,000 cash dividends each year. In other words, the distribution of the profit will cause her, knowingly or not, to act more like an individual acquiring a stake in a private enterprise than a bystander subject to the whims of the stock market.
Second, the need for companies to constantly keep enough cash around each quarter to distribute dividends to stockholders tends to require them to maintain more conservative capitalization structures, subtly reminding management that they are there to produce wealth for the owners of the business—not just make their empire bigger. It also tends to prevent cash hoarding that could inevitably be blown by a CEO feeling pressure from Wall Street to “do something.” Typically, it seems as if the action of choice is to consummate an expensive acquisition, often destroying shareholder value.
Typically, if a well-financed, conservatively run business offers a dividend is yielding 15%, Wall Street is going to recognize the bargain and snap up the shares. If the cash remained on the balance sheet, investors seem more hesitant to swoop in and take advantage of the situation because there is no guarantee that management will allocate the capital wisely.
Cash Dividends vs. Share Repurchases
If you are an investor who needs cash with which to live or who wants to ensure that you, rather than management, can allocate excess profit, you might prefer dividends. If on the other hand, you are interested in finding a company that you truly believe can generate large profits by reinvesting to earn high returns on equity with little on debt, you may favor investing in a firm that repurchases shares.
Wal-Mart, for example, in recent years has decreased the number of shares outstanding while also experiencing high growth and paying cash dividends—one of the perfect combinations in Wall Street history.
Most likely, a hybrid model will be preferred by company directors. At Home Depot, the home improvement chain has returned more than 65% of profits to shareholders in recent years through a combination of aggressive share repurchases and cash dividends.
Brookings Institution. "A Guide to the Fight Over the 'Bush Tax Cuts.' " Accessed March 9, 2020.
SEC.gov. "Purchases of Certain Equity Securities by the Issuer and Others." Accessed March 9, 2020.
Seeking Alpha. "On The Dividend Payout Ratios Of U.S. Stocks." Accessed March 9, 2020.
Multpl. "S&P 500 Dividend Yield by Year." Accessed March 9, 2020.
Dow Jones S&P Indices. "Examining Share Repurchasing and the S&P Buyback Indices in the U.S. Market." Accessed March 9, 2020.
Corporate Finance Institute. "Share Repurchase." Accessed March 9, 2020.
The Wall Street Journal. "Home Depot to Launch 15 Billion-Share Buyback Program." Accessed March 9, 2020.
Home Depot."Dividend History." Accessed March 9, 2020.