Dividends vs. share re-purchases (share buy backs)

Stock repurchases are often touted as an alternative to dividends as both dividends and stock repurchase return money to share holders. There are, however, subtle differences between the two options that make dividends more attractive for long term investors.

The similarities of the both dividends and stock repurchase are illustrated by the hypothetical example shown in the spreadsheet below. Company A and Company B has the same earnings, same PE, and same earnings growth rate (5%). Company A pays out 60% of its earnings in dividends while Company B only pays out 20% but uses 40% of earnings to pay back and retire its own stocks.

One year later, we can compare the returns on these stocks. Both companies have the same total earnings but earnings per share differ. The earning growth per share for Company A equals the organic growth rate of 5%. The Company B earnings per share has grown faster by 8% as there are now less shares. Company A has given a total return of 9% that equals the sum of dividend yield 4% and earnings growth rate 5%. Company B has the same total return (9% that equals the sum of dividend yield 2% and per share earnings growth rate 7%) but it more in form of price appreciation and not hard cash.

We see that the two forms of returning capital are equal except share repurchase delays the benefit to either when investor sells the shares or to later years in forms of faster dividend growth rate. Economist like to argue that given the same total return, a rational investor should choose repurchase over dividends. The repurchase returns the capital to investor in form of price appreciation that the investor can choose to realize at a later date for example for tax reasons.

There are, however, strong arguments against repurchase. The most damming is that companies often buy back their stock when they are doing well and have plenty of cash on hand. The problem with this is that in good times the PE ratios are usually high meaning that the shares are expensive. This is illustrated with the Company C in the spreadsheet. Compared to Company B, everything else is equal but the PE ratio for Company C is higher. Consequently, the company buys fewer shares for the same amount of money and the earnings growth per share is lower. A smart investor would have been happier to receive a special dividend instead.

A smart management of Company D does the opposite: They buy shares when the PE is low allowing them to buy back more shares. The total return is correspondingly higher at 11%. Unfortunately, few companies actually buy back shares when they are cheap.

In the end, the die is cast by follow the money: who really benefits from dividends and stock re-purchases.

Dividends benefit:

+ Investors holding the stock

Stock re-purchases benefit:

+ Investors who sell the stock or hold it long enough to benefit from faster dividend growth rate.

- Wall Street bankers that can collect fees for arranging and advising on re-purchasing.

- Management who owns stock options and have incentive to buy back stock at any price to drive up the stock price.

Put this way, most investors agree that hard cash in terms of dividends serve them best.

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