Cash Dividends vs. Share Repurchases
Which is Better for Your Portfolio?
There's some debate as to whether smart investors should insist on only purchasing shares of businesses that have a consistent record of steady dividend increases, or if it's better for a company to plow its earnings back into the company for expansion through stock repurchases.
Throughout the history of capital markets, many investors have believed that companies existed solely for the sake of generating dividends for the owners, but a fundamental shift away from cash dividends has developed since the 1990s or so.
Cash Dividends vs. Share Repurchases
Investing is the process of laying out money today so it will generate more money for you and your family in the future. Growth in the business should result in eventual changes to your lifestyle, either in the form of nicer material goods or financial independence.
You might prefer dividends if you're an investor who needs cash now to live, or if you want to be sure you—rather than management—can allocate excess profit. But you might favor investing in a firm that repurchases shares if you're 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.
Wal-Mart 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.
A Historical Perspective
Some high-profile, privately-owned family firms have had dramatic schisms over the company's dividend policy. Those involved in the day-to-day operation of the business often want to see the money go into funding growth, but investors simply want larger checks to show up in the mail.
The U.S. tax code is partly responsible for this. It charges up to an additional 15% tax on qualified dividends that are paid out to shareholders. This tax was as high as the graduated income tax before the Bush administration, exceeding 35% on the federal level alone in some cases.
Then Rule 10b-18 was 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.
Rule 10b-18 often resulted in fewer outstanding shares and gave each remaining shareholder a larger percentage ownership in the business.
The dividend payout ratio for all companies in the U.S. was about 55% in 1969. The S&P 500 dividend payout ratio slid to around 25% by 2013, near all-time lows. More statistics tell an even clearer story: The S&P’s 500 dividend yield stood at 2.11% on March 9, 2020, down from 7.44% at the end of 1950.
Total share buybacks have exceeded cash dividends paid by U.S. firms since 1997, according to a report by Harvard Business Review.
Pros and Cons of Share Repurchases
Share repurchases are a more tax-efficient way to return capital to shareholders because there's no additional tax on buybacks, even though the shareholder's pro rata equity in the enterprise increases. This results in potentially more profit and cash dividends on your shares, even if overall sales or profits never increase.
Some problems can undermine these results, however, making repurchases far less valuable:
- Shareholders are harmed if the share repurchases are completed when a company’s stock is overvalued. This is effectively the same as trading in $1 bills for 75 cents, destroying value.
- The repurchases will, at best, neutralize their negative impact on diluted earnings per share if large stock options or equity grants are issued to employees and management.
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.
Dividends Are Psychologically Beneficial
There are some major advantages to cash dividends that simply aren’t available through share repurchases.
Cash dividends can be psychologically beneficial for a shareholder. Imagine a retired schoolteacher living in the suburbs with a portfolio of $500,000. A major market drop of 20%, creating a paper loss, might concern this individual if they were invested entirely in companies that retained all of their capital and/or repurchased stock.
The same loss probably wouldn’t bother them if they were to invest in income-producing equities with an average dividend yield of 4%. They would be consoled by the $20,000 cash dividends they receive each year. The distribution of the profit will cause them to act more like an individual acquiring a stake in a private enterprise than a bystander subject to the whims of the stock market.
Dividends Need Conservative Capitalization Structures
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. This subtly reminds management that they're 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.” It typically seems as if the action of choice is to consummate an expensive acquisition, often destroying shareholder value.
Wall Street is typically going to recognize the bargain and snap up shares when a well-financed, conservatively-run business offers a dividend yielding 15%. Investors seem more hesitant to swoop in and take advantage of the situation if the cash remains on the balance sheet because there's no guarantee that management will allocate the capital wisely.
A Hybrid Example
A hybrid model is usually preferred by company directors. The Home Depot home improvement chain has returned more than 65% of profits to shareholders through a combination of aggressive share repurchases and cash dividends.
Macrotrends. "Walmart Shares Outstanding 2006-2020 | WMT." Accessed May 3, 2020.
Carnegie Corporation of New York. "Andrew Carnegie: Pioneer. Visionary. Innovator." Accessed May 3, 2020.
Brookings Institution. "A Guide to the Fight Over the 'Bush Tax Cuts.' " Accessed May 2, 2020.
SEC.gov. "Purchases of Certain Equity Securities by the Issuer and Others." Accessed May 2, 2020.
Multpl. "S&P 500 Dividend Yield by Year." Accessed May 2, 2020.
Harvard Business Review. "Why Stock Buybacks Are Dangerous for the Economy." Accessed May 3, 2020.
Corporate Finance Institute. "What Is a Share Repurchase?" Accessed May 2, 2020.
Home Depot. "Dividend History." Accessed May 2, 2020.