Share Buyback or Increase Dividends?

Posted by on April 14, 2008 in Investment Information

I am partially appalled and partially impressed by the financial industry’s ability, facilitated by the willing media, to repackage old and discard ideas and sell them as new benefits to average Joe and Mary investor. As the possibility of dividend increases diminishes, there’s been a lot of emphasis and coverage on share buybacks as an alternative to dividends. But is a share buyback really that great or should we, as shareholders, lobby for greater dividends?

A share buyback, as the term implies, is a buyback of shares by the company. It is typically done in one of two ways. The company can make a formal offer to all of the shareholders (called a “normal course issuer bid”) offering to buy back the shares at a premium to the trading price on the day the offer is made. For example, if ABC Corp. is trading at $20.00 on April 1, it offers to all of its shareholders an offer to buy back the shares at $21.50. The other method of carrying out a share buyback is known colloquially as “sweeping the street” whereby the company simply asks a stock broker to buy all the shares tendered for sale on the stock market; the price of the buyback depends on the day’s trading price.

The typical advantage of a share buyback is that it increase earnings per share (EPS) since there are a fewer number of shares. The theory being that since EPS goes up, the stock price should as well. A buyback is also management’s way of telling the world that it believes that its stock is under-valued.

But here are the larger issues with share buybacks:

  • It has traditionally been seen as a “kitchen sink” remedy to appease shareholders. It is the last tactic a board of director utilizes to keep shareholders happy usually after fierce shareholder lobbying “to do something.” A share buyback has historically been viewed as a sign that management has lost all creativity and doesn’t know how to grow the business anymore. Thus, it seems strange that it has been repackaged as some new great thing for shareholders. But such is the sign of the times.
  • A share buyback can be a round-about way of compensating the board and management in tough times without attracting shareholder scrutiny. Boards of directors and senior management are often granted options at prices below the stock’s price on the day of the option grant. Thus, to use the above example, ABC Corp. grants the board options to purchase at $16.00/share when the stock is trading at $20.00. If you trigger a buy-back at $21.50, the board can exercise their options at $16.00/share and immediately sell for a $5.50 gain per share. For companies that issue a lot of options (high-tech and small-cap companies), this can be a back-door method of enriching the option holders and not the shareholders.
  • Unlike a dividend, a buyback does not have to be fully completed. If the company sweeps the street, it can pick and chose when to buy back shares. In a normal course issuer bid, not everyone has to take the buyback offer. Unlike a dividend increase, there is no certainty money will end up in shareholders’ pockets.
  • RESEARCH SHOWS BUYBACKS IN ISOLATION DO NOT INCREASE SHARE PRICE: A Morgan Stanley study found that companies which increased dividends outperformed companies which engaged in buybacks. In fact, share buybacks are only beneficial in falling markets but suffer from the above disadvantages.

A share buyback is not necessarily bad; there’s obviously money in the bank to undertake the buyback but, in isolation and without accompanying dividend increases, it is not as great of a benefit as the companies may make it out to be. If I had to pick between a share buyback and a dividend increase, I pick a dividend increase. There is certainty of payment, management confidence of future performance (since you only increase a dividend if you know you can pay it for many years forward) and studies show that high-dividend stocks perform better than their non-dividend paying counterparts.

On the scale of things, companies that can both increase dividends and engaged in share buybacks are your ideal companies. Companies with no dividend increases engaging in share buybacks are warning signs to me (they may lack imagination and it sends out warning signals that it is trying a band-aid short term solution). Companies engaged only in share buybacks should be looked at very carefully.

According to Standard & Poor’s, the largest buybacks in 2007 (by dollars) were as follows:

  1. Exxon Mobil Corp.
  2. Microsoft
  3. IBM
  4. GE
  5. HP

7 Comments on Share Buyback or Increase Dividends?

By FinancialJungle on April 14, 2008 at 2:26 pm

Well, sometimes it’s good and sometimes it’s bad.

I like using a toll bridge as an example of a cash cow business with little room for safe or creative growth. Return of invested capital may be stellar at 10%. But, if the stock is depressed to a point of yielding 15%, management’s best move is to buy back shares instead of raising dividends.

You got me thinking about this though; a share buyback can be a bad sign if all other players in the same industry are wildly successfully at growing their business.

By MillionDollarJourney on April 14, 2008 at 10:13 pm

What I like about the share buyback is that it’s tax free earnings growth for the investor which hopefully results in higher stock prices. Personally though, I would prefer a dividend any day. Nothing beats cash in your own pocket.

By Dividends4Life on April 16, 2008 at 1:38 pm

Great read! There is room for both and a proper time for each. As FJ points out, when a stock is depressed the best use of the capital is to buy back shares.

Best Wishes,

By Weekly Dividend Investing Roundup - April 18, 2008 » The Dividend Guy Blog on April 18, 2008 at 8:45 am

[...] dividend investors ask is is it better for a company to do a share buyback or raise dividends. Thicken My Wallet had a look at that [...]

By 149th Carnival of Personal Finance - Chasing Dreams Edition | The Happy Rock on April 21, 2008 at 8:49 am

[...] My Wallet presents Share Buyback or Dividend Increase – Thicken My Wallet shares a look into whether a share buyback is all that it is cracked up to [...]

By Dividend Growth Investor on April 28, 2008 at 10:07 pm

The problem with stock buybacks is that the company could vary the amount of stock or amount of money it would use each year to buy back stock. With dividends on the other hand, the company knows exactly what it has to pay each year. If it pays less than anticipated, many shareholders would be unhappy and sell..
I personally enjoy getting dividends, because I am the one who makes the decision how to spend it. If a company buys back stock, that does increase EPS, but then I have to sell stock in order to eat, thus increasing my trading costs..

By >Appearances this week | Saving to Invest on June 4, 2010 at 6:21 pm

[...] >Thicken My Wallet examines the relative pro’s and cons of Share Buyback or Dividend Increase. [...]

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