Three Reasons to Prefer Dividends Over Buybacks

• 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) 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) 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.

Nevertheless, according to a Lehman study, 70% of companies doing buybacks have outperformed the market. Buybacks are a sign of corporate strength and especially strong cash flow. And the presence of a strong buyer on the bid side props up the shares, especially during market pullbacks.

Some companies offer the best of both worlds: a solid dividend and a buyback program. Citigroup (C Quote) has a 4% dividend and its own $15 billion buyback recently completed. Home Depot (HD Quote) pays 2.3% and just increased its buyback authorization from $5 billion to $8 billion through 2009. The new management team is more trustworthy, but the current business climate isn't on their side.

Buyback headlines are nice, but all things considered, I still prefer a check I can cash.