Cash Dividends vs Share Repurchases
Which is Better for Your Portfolio?
John D. Rockefeller, the worlds first billionaire, once remarked that
nothing gave him more pleasure than to see his dividends come into
headquarters. In the five-part article All About Dividends, we provide
an overview of the different types of dividends cash, property, etc.
and the meaning of important dates such as the Ex- Dividend date.
Questions still remain however should a company pay its shareholders
dividends? Should intelligent investors insist only on purchasing
shares of businesses that have a consistent record of steady dividend
increases or is it better for a company to plow all of its earnings
back into the company for expansion? Relax! Were going to take a look
at these issues and more, empowering you to help take control of your
portfolio.
Historical Shift Away from Cash Dividends
Throughout the history of organized capital markets, investors as a
whole seemed to believe that companies existed solely for the sake of
generating dividends for the owners.After all, investing is the
process of laying out money today so that it will generate more money
for you and your family in the future; growth in the business means
nothing unless it results in changes in your lifestyle either in the
form of nicer material goods or financial independence. Certainly,
there was the odd exception Andrew Carnegie, for example, often pushed
his Board of Directors to keep dividend payouts low, instead
reinvesting capital into property, plant, equipment, and personnel.
Some high profile privately owned family firms have had near
cataclysmic schisms over the dividend policy; often you have those
involved in the day to day operation of the business on the one hand
who want to see the money go into funding growth, and on the other,
those who simply want larger checks to show up in the mail.
In recent decades, a fundamental shift away from dividends has
developed. Partly responsible is the U.S. tax code, which charges an
additional 15% tax on dividends paid out to shareholders (before the
Bush administration, this tax was as high as the graduated income tax
in some cases exceeding 35% on the federal level alone). Combined with
the enactment of rule 10b-18, passed by Congress in 1982, protecting
companies from litigation for the first time, widespread repurchases
could be undertaken without fear of legal consequences. As a result,
many high profile Board of Directors made the decision to return
excess capital to shareholders by repurchasing stock and destroying
it, resulting in fewer shares outstanding and giving each remaining
share a larger percentage ownership in the business. Consider that in
1969, the dividend payout ratio for all companies in the United States
was 55%. In April, 2000, the S&P 500 dividend payout ratio hit an
all-time low of 25.3%, according to the newly revised edition of The
Intelligent Investor. More recent statistics tell an even clearer
story: According to Standard and Poors, in fiscal 2005, the S&P 500
generated net income of $634 billion and paid cash dividends of
$201.84 billion on a market value of approximately $11 trillion. One
estimate by Legg Mason shows that share repurchases for the year
approximated an additional $250 billion, resulting in a total return
to shareholders of roughly $451 billion, or 71% of earnings.
Two Major Advantages to Share Repurchases
Share repurchases are clearly a more tax efficient way to return
capital to shareholders because there is no additional tax on buy
backs even though your pro-rata equity in the enterprises increases,
resulting in potentially more profit and cash dividends on your shares
even if overall sales or profits never increase. There is one problem,
however, that can undermine these results, rending repurchases far
less valuable:
If the share repurchases are completed when a companys stock is
overvalued, shareholders are harmed. It is, in effect, the same as
trading in $1 bills for $0.75, destroying value.
If large stock options or equity grants are issued to employees and
management, the repurchases will, at best, neutralize their negative
impact on diluted earnings per share. The actual number of shares
outstanding wont decrease. In this case, the share repurchases are
merely a clever guise for transferring money from the shareholders to
management.
