With all the recent rage about special dividends due to the Fiscal Cliff, I figured now would be a good time to opine on the longtime debate Buybacks or Dividends.
Most Dividend fans point to empirical evidence, while Buyback fans favor theory (how boring!). It is not only hard to argue with either side, I think – although they arrive at different conclusions – they are both correct.
When companies are flush with cash, and therefore announce massive buybacks, it is typically done at a time when the company is doing best and the stock price is the highest. This is the reason most empirical data shows the buybacks are inferior. (Think $MSFT $CSCO $BBY etc.)
The advantage of paying dividends is that they are done systematically (for the most part) and usually quarterly. There is no regard to the fluctuation of the cash position or the company’s stock price.
Theoretically however, buybacks (in most cases) make more sense. They aren’t double taxed like dividends, so the net returns to shareholders are higher. Assuming the company is undervalued (trading under their book value, or ROIC > WACC), buybacks increase the value of the company to the remaining shareholders. Dividends, on the other hand – although shareholders receive cash from the company – it comes out of the company’s balance sheet, and the stock price automatically reflects that by going “ex-dividend”.
So both arguments are right. If a company is holding “extra” cash (because of good business performance, (This is an important point – think $YHOO now vs $CSCO in the past) and has no place to reinvest the money to earn the same return as the rest of the business) then they should pay higher dividends or do a special dividend.
On the other hand, if you’re talking about REGULAR – recurring payments, (or when you have a company that received their ”extra” cash from outside sources) then I believe, IF the company’s return on invested capital is higher than their cost of attaining that capital, or the company is trading at a discount to its book value – buybacks are preferable.
I would NOT (only) do the buybacks at times when the company’s cash balance gets bloated, I would do them daily/weekly/monthly/quarterly. They should be done systematically just as dividends would be. So let’s say XYZ corp has $400M to return to shareholders annually, the same way dividends would probably be $100M each quarter (regardless of stock price), switch it to buybacks and buyback ~$1.6M each trading day (or ~$7.7M each week) systematically etc. This way, you’re taking the stock price and cash balance out of the picture.
Based on my beliefs, most of the corporations that I follow do the exact opposite of what they should! Most companies pay regular dividends and when they have ”extra” cash, they announce massive buybacks. It should be the exact opposite! Have a recurring / systematic buyback, and when you have the “extra” cash – empirically this has been the worst time to do buybacks – pay a one time dividend.