A Preference for Dividends
October 13, 2014
Why do we invest? I assume the answer is similar for most people: to make money. Some of the most common investment vehicles for everyday investors are stocks. People cash their paycheck, close their eyes, pick a few companies, and hope the price goes up. While standard practice, many investors often fail to account for other ways to gain from owning stocks besides simple stock price appreciation. I want to introduce two other ways a company can return cash to shareholders: share repurchases, and dividends.
Share repurchases happen when company management buys its own shares from the market, thus reducing the number of shares available, or float. Dividends on the other hand are a distribution of a company’s net earnings to shareholders, often quoted as a dollar amount (dividend per share ‘DPS’) or a percentage of a stock’s current price (dividend yield). Both measures assume a company (i) has cash, and (ii) is willing and able to return it to shareholders.
Is one of these measures better than the other? Analysts and researchers have been debating this for quite some time. Both have their merits, but both have their shortcomings as well. In the end, it is up for the investor to decide which they prefer, although as you will soon see, the choice may not always be in their hands.
Let’s start with share repurchases, or company buybacks. What can they do for you? The main investment benefit contends as a company’s float decreases, shareholder’s ownership percentage of that stock increases. Hence, the investor gets a larger claim on the company’s potential profits. Other benefits of share repurchases include tax advantages, as you do not owe anything to the government as a result of your increased ownership percentage. They can also be convenient; if you are planning to reinvest or add new money to the stock, the company does this for you by enacting a share repurchase. Lastly, one of the biggest ideas behind buybacks involves the potential for the company’s stock price to increase. When float is reduced, valuation metrics such as Earnings Per Share (EPS) look much better, which has the potential to draw more people to the stock and drive up price. Many investors also believe buybacks reflect a company’s confidence in its future earnings power, and their belief it is undervalued (and thus a great investment).
All of this sounds wonderful in theory, and it can be, but let’s take a look at the flip side of the coin. If you are an investor looking for control and flexibility, share repurchases may not be in your best interest. The company determines when to partake in buyback plans, and investors must be willing to rely on management to determine whether it is an appropriate time to buy back shares or not. There is additional uncertainty here as well since the value of the buybacks depends greatly on the stock’s future price. Let me say this again; the value of the buybacks depends greatly on the stock’s future price. If a company buys back its shares at the wrong time, the results can be detrimental. For example, say a firm decides to buy back 10% of its shares over a period of time, but over the same period, the firm’s stock decreases by 10%. Suppose I own 100,000 out of the firm’s total 1,000,000 shares before the buyback, or 10%. Because of the buyback, I now own 11% of all shares. If earnings stay the same over the period, I have done nicely from an EPS standpoint. However, because of the stock price decline, I have been exposed to potential losses. In such a case, the guaranteed dividend would have been of more benefit to investors. One could argue that a company has the most excess cash during a bull market, which is coincidentally when its share price may be at its highest. Investors depending on share buybacks for value need to trust that management buys at the appropriate time; otherwise they will be leaving a lot of money on the table.
Share price growth from buybacks can also be misleading. The resulting increases in valuation metrics are artificial; the company is not actually growing its business through operations, but through skillful accounting. It is essentially paying to make its metrics look better on paper. In addition, management intentions behind share repurchases may be at times inappropriate, such as executives getting bonuses for hitting EPS targets. Buybacks can also take years to complete, and a company is not legally bound to follow through on its commitments. Furthermore, while buybacks can be more tax efficient than dividends, share price appreciation resulting from buybacks will ultimately be subject to capital gains taxes, which can outweigh the dividend tax rate given the size of the investment. Lastly, and perhaps most intriguing, is the fact that if a company consistently gives its management stock options and its employees stock match as retirement contributions, shares are still being added to the float and repurchases are therefore neutralized.
So are dividends any better to shareholders? We have already seen some of their negatives, such as the tax implications. In addition, like buybacks, dividend timing is not controlled by shareholders. Management is normally not legally bound to follow through on dividend commitments either. So why should we even care about dividends?
Three words – cash is king. I like money, and I like having it now, and I like being able to control what I do with it. Dividends offer far superior flexibility when it comes to cash. Shareholders have complete control of what they do with their dividends. They can use the money to pay bills; they can invest it in other securities; they can even buy back more shares with it! The point is that shareholders have the choice here. Dividends are also extremely dependable. They show a firm is consistently confident in its future cash flows. They decrease share price volatility, and also increase company visibility. On the other hand, buybacks are often just one-time events. Yes, dividend timing is not controlled by shareholders, and management can back out on dividend commitments. Yet history very strongly shows that a decrease or stoppage in dividend payments is rare, since they are looked at very negatively by the market. In times of financial hardships, cutting dividends is often one of the very last measures a company takes in order to stay profitable, and this too is very uncommon. Hence, dividends can even provide cash during economic downswings, with dividend yields acting as protection to a stock’s price during bear markets. Dividends are also normally extended over a set period of time (usually quarterly in the US) giving investors a great level of certainty for fiscal planning. Dividends can also act as a force to keep management disciplined, and run their business efficiently in order to keep consistent dividend growth. This lends itself to the perception of a well run company by the market.
Simple investing comes down to the fact that shareholders invest in companies with decent prospects for economic return. Companies get their capital when they float shares, while investors get a little piece of on-going profits. I vote for the option that, if there is money to be shared, management would give their investors a sure-fire way to get paid – through stable dividend payments, and not just a chance to be paid through discretionary buybacks or stock appreciation.
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