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 back shares 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.

(For more, check out Impact of Share Repurchases)

How Are They Taxed Differently?

The main difference between dividends and buybacks is that a dividend payment represents a definite return in the current timeframe that will be taxed by the taxman, whereas a buyback represents an uncertain future return on which tax is deferred until the shares are sold. Note that in the United States, qualified dividends and long-term capital gains are taxed at 15% up to a certain income threshold that is quite high ($425,800 if filing singly, $479,000 if married and filing jointly), and at 20% for amounts exceeding that limit.

An Example of Dividend Versus Buyback

Let's use the example of a hypothetical consumer products company that we will call Footloose & Fancy Free Inc. (symbol FLUF), that has 500 million shares out in Year 1. The shares are trading at $20, giving FLUF a market capitalization of $10 billion. Assume that FLUF had revenues of $10 billion in Year 1 and a net income margin of 10%, for net income (or after-tax profit) of $1 billion or $2 per share. This means that the stock is trading at a price-to-earnings multiple (P/E) of 10 (in other words, $20 / $2 = $10).

Suppose that FLUF is feeling particularly generous toward its shareholders and decides to return its entire net income of $1 billion to them. This could play out in one of two simplified scenarios.

Scenario 1: Dividend. FLUF pays out $1 billion as a special dividend, which amounts to $2 per share. Assume you are a FLUF shareholder and you own 1,000 shares of FLUF purchased at $20 a share. You therefore receive (1,000 shares x $2/share) or $2,000 as the special dividend. At tax time you pay $300 as tax (at 15%), for an after-tax dividend income of $1,700, or an after-tax yield of 8.5% ($1700 / $20,000 = 8.5%).

Scenario 2: Buyback. FLUF spends the $1 billion buying back FLUF shares. Although a company will execute its share buyback over a period of many months and at different prices, to keep things simple, we assume that FLUF buys back a huge share block at $20, which amounts to 50 million shares bought back or repurchased. This reduces its share count from 500 million shares to 450 million shares.

The 1,000 shares of FLUF that you purchased at $20 will now be worth more over time because the reduced share count will boost the value of the shares. Assume that in Year 2, the company's revenues and net income are unchanged from Year 1 at $10 billion and $1 billion respectively. However, because the number of shares outstanding is now down to 450 million, earnings-per-share would be $2.22 instead of $2. If the stock trades at an unchanged price-to-earnings ratio of 10, FLUF shares should now be trading at $22.22 ($2.22 x 10) instead of $20.

What if you sold your FLUF shares at $22.22 after holding them for just over a year and paid the long-term capital gains tax of 15%? You would be taxed on capital gains of $2,220 (i.e., ($22.22 - $20.00) x 1,000 shares = $2,220) and your tax bill in this case would be $333. Your after-tax gain would thus be $1,887, for an after-tax return of approximately 9.4% ($1,887 / $20,000 = 9.4%).

Additional Considerations

Of course, in the real world, things seldom work out so conveniently. Here are some additional considerations with regard to buybacks versus dividends:

  • The future return with a share buyback is anything but assured. For instance, let's say that FLUF's business prospects tanked after Year 1, and its revenues fell 5% in Year 2. Unless investors are willing to give FLUF the benefit of the doubt and treat its revenue decline as a temporary event, it is quite likely that the stock would trade at a lower price-per-earnings multiple than the 10 times earnings at which it generally trades. If the multiple compresses to 8, based on an earnings-per-share of $2.22 in Year 2, the shares would be trading at $17.76, a decline of 11% from $20.
  • The flip side of this scenario is one enjoyed by many blue chips, in which regular buybacks steadily reduce the number of outstanding shares. This can significantly boost earning-per-share growth rates even for companies with mediocre top-line and bottom-line growth, which may result in them being accorded higher valuations by investors, driving up the share price.
  • Share buybacks may be better for building wealth over time for investors because of the beneficial impact on earnings-per-share from a reduced share count, as well as the ability to defer tax until the shares are sold. Buybacks enable gains to compound tax-free until they are crystallized, as opposed to dividend payments that are taxed annually.
  • In the case of non-taxable accounts where taxation is not an issue, there may be little to choose between stocks that pay growing dividends over time, and those that regularly buy back their shares, as discussed in the next section.
  • A major advantage of dividend payments is that they are highly visible. Information on dividend payments is easily available through financial websites and corporate investor relations sites. Information on buybacks, however, is not as easy to find and generally requires poring through corporate news releases.
  • Buybacks provide greater flexibility for the company and its investors. A company is under no obligation to complete a stated repurchase program in the specified timeframe, so if the going gets rough, it can slow down the pace of buybacks to conserve cash. With a buyback, investors can choose the timing of their share sale and consequent tax payment. This flexibility is not available in the case of dividends, as an investor has to pay taxes on them when filing tax returns for that year. For a dividend-paying company, although dividend payments are discretionary, reducing or eliminating dividends is generally not an option as disgruntled shareholders may sell their shareholdings en masse if the dividend is reduced, suspended or eliminated.
  • Timing is critical for a buyback to be effective. Buying back its own shares may be regarded as a sign of management’s confidence in a company's prospects. However, if the shares subsequently slide for any reason, that confidence would be misplaced.
  • Soaring corporate buybacks may be regarded as excessive by some investors, since the amounts spent on buybacks could be invested back into the business as capital expenditures or to perform research and development. In the six-year period from June 2009 to June 2015, S&P 500 companies had repurchased a record $2.7 trillion of shares, coinciding with the second-longest U.S. bull market since the 1950s. In 2014, S&P 500 companies returned $903 billion through dividends and buybacks to their shareholders, with buybacks comprising $553 billion of the total and a record $350 billion paid out in dividends. Numerous U.S. companies (including Apple Inc. (AAPL) have taken advantage of record low interest rates to borrow money and distribute the proceeds to their shareholders through dividends and buybacks.

    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.

    The Bottom Line

    Buybacks and dividends can significantly boost shareholder returns. There are a number of exchange-traded funds that track the S&P 500 Dividend Aristocrats Index (for example, the ProShares S&P 500 Dividend Aristocrats ETF) and the S&P 500 Buyback Index (such as the PowerShares Buyback Achievers Portfolio).