Top 1%
Three Reasons to Prefer Dividends Over Buybacks
Jennifer Openshaw
06/15/07 - 11:53 AM EDT
The rate of share repurchases is growing at a torrid pace. S&P 500 Index companies bought back a stunning $432 billion in shares in 2006 -- almost 59% of reported earnings and up from 45% in 2005. This is huge.
Furthermore, these repurchases increased earnings about 4%, going a long way to explain the S&P's double-digit growth rates.
So is this a good thing for The Millionaire Zone investors?
Or if big companies have so much cash to throw around, would you be better off if they paid you a dividend instead?
Let's take a closer look.
- A bird in the hand. As the adage goes, it's better than two elsewhere. Cash is cash, and when you receive a dividend, you don't rely on the so-called market mechanism to deliver value. Better yet, a dividend is like an ongoing commitment to continue paying cash to investors. A stated payout isn't a contractual commitment, but especially for investment-grade corporations, it isn't likely to be retracted anytime soon. And tax implications follow the "bird in hand" theory. Dividends are taxed at a rate not exceeding 15% even for AMT, while a capital gain -- from a share price increase tied to a buyback -- may be taxed at ordinary rates if the stock is sold within a year. And if you wait more than a year, who knows what the tax law will be? So the dividend, at least for now, locks in the lower rate.
- You can't cash in on an announcement. A buyback announcement is just that -- it's an announcement. Shares may react to the announcement, but there's nothing to guarantee that the reaction will match the size of the buyback. Case in point: Wal-Mart (WMT Quote - Cramer on WMT - Stock Picks) just announced a massive $15 billion share repurchase, amounting to some 7.2% of shares outstanding. The stock was up just over 4% on the announcement. Further, there is no guarantee that the buyback will happen at all. Announcements aren't contractual commitments, and what the company actually does in the marketplace doesn't have to match the announcement. It just can't exceed the announcement amount filed with the SEC. Surprisingly, it's pretty hard to determine whether a company actually acts out its intentions. You have to dig deeply into financial statements or listen closely to conference calls. Dividends are far more transparent.
- Games people play. It's just too darned easy for management to get creative with buybacks. First, and most obviously, a buyback accomplishes nothing if the company is granting just as many shares on the back end for options. This was especially an issue for tech companies in the late 1990s, and it can happen either before or after the options are granted. Sun Microsystems (SUNW Quote - Cramer on SUNW - Stock Picks) just announced a $3 billion buyback, which at current prices would retire 600 million shares. The only thing is, share counts have risen by 300 million just in the past three fiscal years. So the buyback makes a nice headline, but it only accomplishes half of what investors might hope for -- and less if the company doesn't execute on the announcement. Also, some companies will buy back shares only to reissue them for cash or for suspect acquisitions. So if you're counting on a buyback, check shares outstanding occasionally to see if the buyback really is reducing share count. Lastly, watch out for companies that use debt to finance buybacks. Sure, debt is pretty cheap right now. But debt brings real expenses -- interest -- while in some cases not creating any real earnings growth. Earnings per share improves because the company has now reduced share count, but the earnings itself has not increased.