A Preference for Dividends

A Preference for Dividends

Simple investing comes down to the fact that shareholders invest in companies with decent prospects for economic return.

Why do we invest?  The answer for most is to make money.  Some of the most common investment vehicles are stocks. People cash their paycheck, close their eyes, pick a few companies, and hope the price goes up. While standard practice, many investors often fail to account for other ways to gain from owning stocks besides simple stock price appreciation.

I want to introduce two other ways a company can return cash to shareholders: share repurchases, and dividends. Share repurchases happen when company management buys its own shares from the market, thus reducing the number of shares available, or float.  Dividends are a distribution of a company’s net earnings to shareholders, often quoted as a dollar amount (dividend per share ‘DPS’) or a percentage of a stock’s current price (dividend yield).

Both measures assume a company (i) has cash, and (ii) is willing and able to return it to shareholders. Is one better than the other? Analysts and researchers have been debating this. Both have their merits, both have their shortcomings.  In the end, it is up for the investor to decide which they prefer, although as you will soon see, the choice may not always be in their hands.

Let’s start with share repurchases.  The main benefit contends that as a company’s float decreases, shareholder’s ownership percentage of that stock increases. Other benefits of share repurchases include tax advantages, you do not owe anything to the government as a result of your increased ownership percentage. Also, if you are planning to reinvest or add new money to the stock, the company in effect does this for you by enacting a share repurchase.  One of the biggest ideas behind buybacks involves the potential for the company’s stock price to increase. When float is reduced, valuation metrics such as Earnings Per Share (EPS) look much better, which has the potential to draw more people to the stock and drive up price. Last, many investors also believe buybacks reflect a company’s confidence in its future earnings power.

This sounds wonderful, but take a look at the flip side. If you are looking for control and flexibility, share repurchases may not be in your best interest. The company determines when to partake in buyback plans, and investors must rely on management to determine whether it is an appropriate time to buy back shares or not. There is additional uncertainty since the value of the buybacks depends greatly on the stock’s future price. If a company buys back its shares at the wrong time, the results can be detrimental. For example, say a firm decides to buy back 10% of its shares over a period of time, but over the same period, the firm’s stock decreases by 10%.

Suppose I own 100,000 out of the firm’s total 1,000,000 shares before the buyback, or 10%. Because of the buyback, I now own 11% of all shares. If earnings stay the same over the period, I have done nicely from an EPS standpoint. However, because of the stock price decline, I have been exposed to potential losses. In such a case, the guaranteed dividend would have been better.

Investors depending on share buybacks for value need to trust that management buys at the appropriate time; otherwise they will be leaving a lot of money on the table. Share price growth from buybacks can also be misleading.

The resulting increases in valuation metrics are artificial; the company is not actually growing its business through operations, but through skillful accounting.  In addition, management intentions behind share repurchases may be inappropriate, such as executives getting bonuses for hitting EPS targets. Buybacks can also take years to complete, and a company is not legally bound to follow through on its commitments.

Furthermore, while buybacks can be more tax efficient than dividends, share price appreciation resulting from buybacks will ultimately be subject to capital gains taxes, which can outweigh the dividend tax rate given the size of the investment. Last, if a company consistently gives its management stock options and its employees stock match as retirement contributions, shares are still being added to the float and repurchases are therefore neutralized.

So are dividends better? We’ve seen some negatives, such as tax implications. Like buybacks, dividend timing is not controlled by shareholders. Management is normally not legally bound to follow through on dividend commitments either. So why dividends? Three words – cash is king.

I like money.  I like having it now.  I like being able to control what I do with it. Dividends offer far superior flexibility when it comes to cash. Shareholders have complete control of what they do with their dividends. They can use the money to pay bills; they can invest it in other securities; they can even buy back more shares with it! 

Dividends are extremely dependable. They show a firm is confident in its future cash flows. They decrease share price volatility, and also increase company visibility. Buybacks are often just one-time events. Yes, dividend timing is not controlled by shareholders, and management can back out on dividend commitments. Yet history very strongly shows that a decrease or stoppage in dividend payments is rare, since they are looked at very negatively by the market. In times of financial hardships, cutting dividends is often one of the very last measures a company takes in order to stay profitable, and this too is very uncommon. Hence, dividends can even provide cash during economic downswings, with dividend yields acting as protection to a stock’s price during bear markets.

Dividends normally extend over a set period of time (usually quarterly in the US) giving investors a great level of certainty for fiscal planning. Dividends also keep management disciplined, and run their business efficiently in order to keep consistent dividend growth. This lends itself to the perception of a well-run company by the market.

Simple investing comes down to the fact that shareholders invest in companies with decent prospects for economic return. Companies get their capital when they float shares, while investors get a little piece of on-going profits. I vote for the option that, if there is money to be shared, management would give their investors a sure-fire way to get paid – through stable dividend payments, and not just a chance to be paid through discretionary buybacks or stock appreciation.

 

Eric Ervin is Co-Founder, President and CEO of Reality Shares, Inc., an index and research firm. 

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