We are truly in the golden age of cash flow.
#-ad_banner-#Corporate profit margins have been so strong in
recent years that companies have been pulling in large sums of
cash every quarter. In the first few years after the economic
crisis of 2008, companies sought to hoard their cash, but
starting around 2010, growing share buybacks and rising dividends
became the name of the game.
Companies now dole out almost as much as they take in, leaving
cash balances fairly static. That's fine: Companies are
well-cushioned against the next (and inevitable) economic
downturn. And with cash flow continuing to pour in as margins
remain near peak levels, look for more dividend hikes and fresh
About the only thing that could derail the
buyback-and-dividend freight train
would be an increase in acquisitions
-- but most companies are continuing to eschew acquisitions and
the risks they entail.
In the context of solid dividends and buybacks, it's fair to
ask: Is it better to own a company that produces solid and
predictable dividends, or one that plans on buying back stock?
Let's take a look at the pros and cons of each scenario, starting
|Scenario 1: The Company Begins
The appeal of dividends lies in the production of income
that investors receive. In a world of certificates of
deposit (CDs) and government bonds that yield just 1% or
2%, dividend-paying stocks that can pay a 3%, 5% or even
7% yield are highly appreciated.
And many investors think that a robust dividend forces
discipline on a company, making management focus on
maintaining a steady cash flow that's returned to
shareholders rather than using that cash for riskier
moves -- like acquisitions -- that may not pay off.
The downside of dividends: double taxation. Unless you
own the stock in a tax-favored retirement account, you'll
pay the capital gains tax rate on those dividends. That's
after companies have already paid their share of taxes on
profits (unless they are real estate investment trusts
(REITs) of master limited partnerships (MLPs) which allow
for a "pass-through" of profits).
|Scenario 2: The Company Buys Back
Its Own Stock
Because dividend payouts can trigger unwanted taxes for
an investor, many prefer to see the company announce
share buybacks. When a company buys back stock, it
reduces the number of shares outstanding, which boosts
earnings per share (earnings divided by shares
For example, company ABC earns $100. If there are 10
shares outstanding, the company's earnings per share is
$10 ($100/10 shares = $10/share). But if company ABC buys
back six shares, leaving only four shares outstanding,
earnings per share suddenly increases to $25 ($100/4
shares = $25/share).
Even though the amount of money company ABC earned is
still the same, the earnings per share (
) more than doubled, just from reducing the number of
shares outstanding. As you can see, when companies buy
back stock, it increases each share's value. Sometimes
the increased share value attracts new investors, further
driving up prices.
Yet stock buybacks have one glaring flaw: Companies sometimes
buy back their stock at the wrong time -- usually when they
thought their share prices were undervalued. Telecom equipment
surely regrets spending more than $2.5 billion in 2007 to acquire
more than 100 million shares of its stock, only to find that its
stock would go on to plunge in value. Spending the same amount
today would have retired more than 300 million shares.
But there's another potential risk that shareholders should
know about company buybacks: Many buybacks are really just
covering up overly generous stock option grants to executives and
don't actually boost EPS.
As I noted back in December
in a look at which buyback programs had real teeth, regional bank
, announced buybacks that equated nearly 5% of shares
outstanding. But the share count barely budged, meaning most of
that $800 million went toward enriching executives, not
Such companies counter that their share counts would have
swelled far higher if the buybacks hadn't been enacted, but
that's a pretty lame excuse.
So Are Buybacks Or Dividends Better?
In recent years, the buyback approach has been more profitable.
Companies buying back stock tend to see a share price
appreciation that is greater than yield delivered by dividends.
As an example,
PowerShares Buyback Achievers ETF (NYSE:
, which focused on companies in the midst of buybacks, has
outperformed the S&P 500 by 50 percentage points over the
past five years. You would have had to garner an 8.5% annual
dividend from your portfolio to attain a similar return.
Still, it's fair wonder if buybacks still hold appeal, now
that the stock market (and most stocks) are far higher than they
were five years ago. Higher share prices suggest that companies
are getting less bang for their buck, and a pivot towards
dividends would be prudent. We're likely to see such a shift when
interest rates rise and companies feel pressure to deliver yields
that stay ahead of fixed-income instruments such as bonds and
And as noted earlier, not all buyback programs hold equal
appeal. You should be sure to monitor whether the share count is
truly falling from quarter to quarter once buybacks are
announced. Not only might these buyback programs be in place
merely to offset stock option grants, but they may not even be
pursued at all. Some companies say they "may buy up to" a certain
amount of stock but never actually bother.
Risks to Consider:
Buybacks and dividends can mask the fact that management
lacks creative uses for its cash that can expand sales and
Action to Take -->
The charm of dividends is that they can't be fudged. Unlike
buybacks, a dividend promised is a dividend delivered. Still, in
this low interest-rate environment, shareholders will glean
better rewards from buyback plans. For a look at my current
favorite buyback plays,
check out this recent article