Stock Buybacks versus Dividends

There was an article written by Jennifer Openshaw last week on TheStreet.com entitled Three Reasons to Prefer Dividends Over Buybacks. A lot of people agree with that opinion, namely that dividends are cash in your pocket, which is preferable to a stock buyback. However, I’m not so sure I personally prefer a dividend payment. Let me explain why by playing devil’s advocate for the three reasons cited in Jennifer’s article.

1) “Dividends are taxed at a rate not exceeding 15% while a capital gain may be taxed at ordinary rates if the stock is sold within a year. And if you wait more than a year, who knows what the tax law will be? So the dividend, at least for now, locks in the lower rate.”

I can think of a few different scenarios and only one of them results in the dividend being the better alternative from a tax perspective. If you own the stock in a retirement plan, tax rates are irrelevant. If we are talking about a taxable account, a dividend payment triggers a taxable event, meaning you pay the 15% tax on the dividend payment in the year you receive it, regardless of whether you sold the stock or not. Buybacks don’t trigger taxes.

The argument that the tax law could change in the future, therefore you should lock in a low rate, is a poor one. Typically when capital gains rates change, they are not retroactive. If you bought a stock in 2005 and the long term capital gains tax rate goes up in 2010, you don’t get stuck paying the higher rate when you sell the stock when the law was different.

In my view, the only time dividends are more beneficial from a tax perspective is when you hold a stock in a taxable account and you sell it in less than 12 months. I would argue this occurs less often than not. Most traders don’t rely on dividend paying stocks. Long term investors are more likely to have high levels of dividend income. Also, many investors have the bulk of their investments in tax-sheltered accounts.

2) “You can’t cash in on an announcement. there is no guarantee that the buyback will happen.”

I think this argument is weaker than the first one. The article is supposedly comparing dividends to stock buybacks, not dividends to stock buyback announcements. Obviously, given the choice between a dividend payment and a buyback announcement that doesn’t happen, you would take the dividend. If you are going to compare dividends and buybacks, I think you have to simply assume you are comparing a $1 paid out to shareholders with a $1 used to repurchase shares.

A lot of buyback opponents will throw out the argument that some buybacks are announced and never implemented, but the vast majority of buybacks are actually completed, not just announced and then thrown under the rug. If you are debating which use of cash is better, I think you need to assume the announced dividends get paid and the announced buybacks are implemented.

3) “A buyback accomplishes nothing if the company is granting just as many shares on the back end for options.”

This one is simply untrue. Assume you have two companies, all else equal, except one issues 1 million options per year without a buyback program and the other company issues the same 1 million options per year but also buys back 1 million shares in the open market with available free cash flow. Did the second company accomplish anything? Absolutely!

Stock buybacks are accretive to earnings per share, regardless of whether or not the company issues options or not, simply because buying back stock is better than not buying back stock. A company’s earnings per share will always be higher if they buy back stock compared to if they don’t. How many options the company issues to employees, if any, makes no difference. Of course, the higher the repurchased share to issued options ratio, the better off investors will be.

For the most part, I don’t think the reasons to prefer dividends cited in this particular article are very compelling. If you are seeking income from your stock portfolio, clearly you would prefer dividends. Other than that, I think share buybacks in many cases are just as good as dividends. In fact, if you are a long term investor in a taxable account, I would prefer a buyback because it postpones the payment of taxes. Anytime you can postpone paying someone something, especially the federal government, the time value of money is working in your favor.

So which do you prefer? A dollar of a company’s free cash flow paid out to you or used to increase your ownership percentage of the company?