Weighing the scale: dividends vs buybacks

WE ALL want to earn something from our investments. Isn’t that why we invest in the first place?

But how we actually reap our rewards can be an entirely different matter. There are several ways that we can be compensated when we invest in shares. One is through dividends. Another way is through share-price appreciation, which can be propelled through share buybacks.

But which is better – dividends or share buybacks?

Some might argue that they are two sides of the same coin. In the first instance, a company distributes a proportion of the profit it has made to shareholders directly. It is an explicit reward for shareholders. The second method of share buybacks is slightly more nuanced.

We often find that news of a share buyback programme can provide a welcome fillip to a stock that might otherwise be underperforming. Whether the share buyback is actually executed is an entirely different matter. There is no guarantee it will even happen. But announcing a dividend – or, better still, raising a payout – can show that a company is more confident about its future. Which of the two is more beneficial to shareholders?

Dividends versus buybacks

Announcements of plans to initiate a share buyback can have a pronounced and positive effect on a company’s share price. It doesn’t even seem to matter should a company tell the market that its financial performance was underwhelming, and that expectations for the future are disappointing.

What does seem to count is that the company will be handing back money to shareholders through buybacks.

There’s nothing new about a company wanting to return surplus money to shareholders. After all, many companies pay dividends, which is one way that cash is distributed to those who have a stake in the business. However, share buybacks can be more subtle. Warren Buffett once said: “Repurchases are all the rage. But they are all too often made for an unstated, ignoble reason – to pump up or support the stock price.”

He went on to add: “There is only one combination of facts that makes it advisable for a company to repurchase its shares: when the company has available funds beyond the near-term needs of the business, and finds its stock selling in the market below its intrinsic value.”

When companies buy back their own shares, they immediately reduce the number of outstanding shares on the market. This can boost earnings per share, even though profits may be static. Consequently, it may give the appearance that a business is doing better, even if it might not be.

Apart from earnings per share, other closely watched financial ratios might improve too, after shares have been repurchased. Return on assets is one ratio that could improve after a buyback because cash is an asset. Return on equity might improve because there is less outstanding equity for every pound of profit generated by the business.

So, ploughing money into share buybacks can be a good way to improve the efficiency ratios of businesses, albeit artificially.

Dividends are different

Unlike buybacks, dividends represent real cash in the pockets of shareholders. To my knowledge, it is not possible to fake a dividend cheque hitting a bank account. Dividend yields are also a tangible measure of how expensive a business is relative to the market.

But paying a dividend represents a huge obligation on the part of management. Once a company commits to a level of payout, it can be very difficult to reduce or scrap it later on. On the other hand, few of us will ever notice if a company decides to stop buying back its shares. So which is better, dividends or buybacks?

The answer, as with most financial issues, is that it depends. When share buybacks were introduced, they were devised as an efficient way to return cash to shareholders. This still applies today, especially if dividends are taxable or if income tax is higher than capital gains tax. In some countries, neither is taxable, so the question doesn’t even arise.

However, share buybacks effectively deny investors the right to allocate cash in a way that they consider most appropriate. A company might want to buy back its shares because, in its opinion, they are undervalued. But an investor with a portfolio of shares might think otherwise. There could be other shares in the portfolio that could be even more undervalued.

Still, we shouldn’t get too hung up on whether share buybacks or dividends are better. What really matters is whether a business is able to generate enough free cash flow to allow it to do what it wants.

As we enter a period of slower economic growth and tightening credit conditions, free cash flow will be vital for survival. Cash is king.

The writer is co-founder of The Smart Investor