Companies that consistently post solid profits often find themselves faced with an enviable challenge: deciding what to do with the cash piling up in their bank accounts.
An embarrassment of riches is obviously a great problem to have. But many companies find disposing of excess cash a taxing affair. Firms with significant growth opportunities almost always reinvest their excess free cash flow back into the business, whether to expand current operations, acquire new capabilities, increase R&D, etc. Growth companies rarely run out of things in which to invest. For mature companies, where growth is more modest, excess cash can become a burden. Thus, many opt to return the money to their shareholders.
Companies have two standard methods of excising excess cash: return it directly to shareholders as dividends or use it to buy back shares. Both methods have their supporters, but which should investors view as superior? We addressed this question in the specific context of Apple Inc. (AAPL, Financial) in a recent research note, in which we discussed the tech giant’s recent aggressive buyback activities.
In this research note, the first entry of a two-part study, we discuss how dividends and share buybacks compare and contrast. We aim to offer investors a clear picture of these two methods of achieving what is ultimately a similar goal: putting companies’ cash to work for the benefit of shareholders.
Let’s get started.
New kid on the block: dividends endure as buyouts soar
First off, it is important to understand the backdrop concerning share buybacks and dividends. For most of the 20th century, dividends were the only legal method in the United States for corporations to return cash to shareholders. That changed during the Reagan administration, which revamped the SEC to reflect the president’s free-market agenda. Aswath Damodaran, a professor of finance at New York University, offers a succinct explanation of the changes wrought by this new, market-friendly SEC:
“In the United States, the pace of buybacks did not really start picking up until the early 1980s, which some attribute to a Securities and Exchange Commission rule (10b-18) passed in 1982, providing safe harbor (protection from certain lawsuits) for companies doing repurchases...While dividends represented the preponderance of cash returned to investors in the early 1980s, the move toward buybacks became clear in the 1990s, and the aggregate amount in buybacks exceeded the aggregate dividends paid from 2005 to 2007. In 2007, the aggregate amount in buybacks was 32% higher than the dividends paid in that year.”
Unsurprisingly, buybacks dropped off during the last recession as companies retrenched and sat on their cash warchests. But that proved to be a blip, and buybacks roared back to life once the next growth cycle got rolling in 2009.
Dividends were in wide use when there was no other legal method of returning cash to shareholders. Then, almost as soon as they were made permissible, share buybacks became commonplace. Indeed, it took a mere decade for the aggregate value of buybacks to exceed that of dividends.
Yet, while buybacks long ago surpassed dividend payouts in popularity among company managers, the older method of returning cash to shareholders is still very much a fixture of corporate finance and investing today.
Consistency: regular payouts vs. opportunistic & programmatic action
Dividends remain in wide use across a host of industries. REITs, established industrial companies, and a host of other consistent earners rely on dividends as part of their core value proposition.
Share buybacks, on the other hand, tend to be programmatic and opportunistic. This means that, generally speaking, buybacks do not happen at fixed intervals in perpetuity (as is the case, theoretically, with a high quality dividend stock). Buybacks are often opportunistic, taking advantage of factors such as temporary share price weakness or deploying one-off windfalls.
This is not to say that dividends cannot be erratic; of course they can. And companies will occasionally even issue special dividends when they beat earnings guidance or notch a one-off win. But, fundamentally, dividends are marked by a far greater level of consistency.
Investor goals: income generation vs. capital appreciation
High quality dividend-paying stocks are marked their ability to make regular cash payouts. This is a key attractor for many investors, especially those with a more conservative bent. Companies with strong and stable (and preferably growing) dividends are coveted by income-focused investors especially. Regular payouts add stability and certainty to investors’ returns, and the dividend income is often an important source of liquid funds for individual shareholders to utilize elsewhere.
With a share buyback, cash is not changing hands in quite the same way. Shareholders interested in a one-off payout can sell their shares back to the company, trading stock for cash. But the majority of shareholders in a buyback context will keep their shares. In a buyback, shareholders do not receive cash directly. Instead, they experience effective capital appreciation thanks to a reduction in the number of shares outstanding.
At the most basic level, each share of a company’s stock represents a right to a fixed percentage of a company’s future cash flows, as determined by the number of extant shares. A reduction in share count results in an attendant increase in the value of each surviving share. And, as a bonus, fewer shares will tend to boost reported earnings per share, which can feed the cycle of capital appreciation. For investors not seeking regular income, this may be a preferable alternative to dividend payments, since, instead of disbursing (or should we say dispersing?) cash, buybacks arguably offer a greater likelihood of compound growth.
Tax implications: pay now vs. pay eventually
As we discussed in our recent note on Apple’s huge share buyback program, there is a thicket of tax implications to consider when comparing the relative merits of dividends and share buybacks. Not to put too fine a point on it, dividends’ tax efficiency varies based on investors’ individual circumstances while the impact of buybacks is largely uniform. Ultimately, it is a matter of when tax comes due, and what exemptions apply to the specific investor:
“The main difference between dividends and buybacks is that a dividend payment represents a definite return in the current timeframe that will be taxed by the taxman, whereas a buyback represents an uncertain future return on which tax is deferred until the shares are sold. Note that in the United States, qualified dividends and long-term capital gains are taxed at 15% up to a certain income threshold that is quite high ($425,800 if filing singly, $479,000 if married and filing jointly), and at 20% for amounts exceeding that limit.”
Buybacks can be thought of as “cleaner” option insofar as they have no immediate tax implication for investors. When a shareholder sells their stock, then they will be liable for capital gains tax.
A dividend, on the other hand, is taxed upon receipt of payout. Thus, depending on the extent of tax levied at each interval, as well as the particular tax status of the investor (or their account), regular dividend payments might prove rather inefficient.
Next time…
In our next research note, we will conclude our discussion of dividends and share buybacks by assessing the real performance of stock indices that serve well as proxies for the strategies writ large.
The comparative gets very interesting once we bring the discussion from the realm of theory into real world application. Stay tuned!
Disclosure: No positions.
