Question

Considering the differences other than personal income taxes, what companies should pay dividends rather than repurchase shares? How important is the right choice between the two?

Answer 1

Companies reward their shareholders in two main ways — by paying dividends or by buying back their shares. An increasing number of blue chips are now doing both. Paying dividends and buying backshares is a potent combination that can significantly boost shareholder returns. But which alternative is the better one for investors?

What Is a Dividend?

Dividends are a share of profits that a company pays at regular intervals to its shareholders. Investors like dividend payers because dividends form a major component of investment return, contributing nearly one-third of total returns for U.S. stocks since 1932, according to Standard & Poor’s (capital gains account for the other two-thirds).

Companies typically pay out dividends from after-tax profits. Once received, shareholders must also pay taxes on dividends, albeit at a favorable tax rate in many jurisdictions.

Start-ups and other high-growth companies such as those in the technology sector rarely offer dividends. These companies often report losses in their early years, and any profits are usually reinvested to foster growth. Larger, established companies with more predictable profits are often the best dividend payers.

What Is a Buyback?

A share buyback refers to the purchase by a company of its shares from the marketplace. The biggest benefit of a share buyback is that it reduces the number of shares outstanding for a company. This usually increases per-share measures of profitability like earnings-per-share (EPS) and cash-flow-per-share, and also improves performance measures like return on equity. These improved metrics will generally drive the share price higher over time, resulting in capital gains for the shareholders. However, these profits will not be taxed until the shareholder sells the shares and crystallizes the gains made on the shareholdings.

A company can fund its buyback by taking on debt, with cash on hand or with its cash flow from operations

Dividends Versus Buybacks: Which Stocks Perform Better?

Which group of companies has performed better over time, the ones that consistently pay increased dividends or the ones that have the biggest buybacks? In order to answer this question, let's compare the performance of the S&P 500 Dividend Aristocrats Index (companies that have raised dividends every year for the last 25 consecutive years or more) against the S&P 500 Buyback Index (top 100 stocks with the highest buyback ratio as defined by cash paid for share buybacks in the last four calendar quarters divided by the company's market capitalization). Here's how the two stack up:

In the period from January 2000 to June 2015, the Buyback Index and Dividend Aristocrats Index were neck-and-neck, with an annual return of 9.90% and 9.89% respectively. Both trounced the S&P 500, which had an annual return of only 4.18% over this period.
Over the ten year span of 2008-2017, the Buyback Index had an annual return of 12.64%, compared with 10.39% for the Dividend Aristocrats Index. Meanwhile, the S&P 500 had annual returns of 7.81% over this period.
What about the 16-month period from November 2007 to the first week of March 2009, when global equities endured one of the biggest bear markets on record? During this period, the Buyback Index slumped 53.32%, while the Dividend Aristocrats held up better, with a decline of 43.60%. The S&P 500 tumbled 53.14% during this period

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