What Creates More Value for Investors: Dividend Payout or Share Repurchases?

In this article, we’ll explore the major pitfalls associated with share repurchases and why dividends payouts are far more valuable from an investor’s perspective.

Share repurchases or company buybacks occur when a publicly-traded company decides to repurchase shares of its stock. Buybacks can be performed on the open market or via private transactions directly from existing shareholders. Although buybacks are usually marketed as a form of “re-investment” in the company, they are designed solely to benefit the corporation and its insiders as opposed to shareholders themselves. In this sense, buybacks provide greater flexibility from management’s point of view, but create little value for investors.

Buybacks are also appealing from a management perspective because they are not sticky, which means there is no recurring expectation to increase buybacks at a later date.

However, that doesn’t mean buybacks are completely worthless from an investor’s perspective. In certain circumstances, buybacks have the potential to create value for investors. This usually occurs when a company’s share price is undervalued. Buybacks are also useful for investors looking to reinvest their dividends back into the company. In this case, repurchases essentially do it for you.

From the perspective of the corporation, buybacks don’t always create value. Michael Dell’s buyback of struggling P.C. maker Dell Inc. (DELL ) is a case in point. In partnership with Silver Lake Partners, Dell privatized his company in a $25 billion ($13.75 a share) buyback deal that was finalized in 2013. However, it was later found that the company was undervalued at the time of the buyback, resulting in a lawsuit. It was later decided that the fair-market value of Dell was $17.62 a share – a price point that no one was willing to pay.

Check out our Dividend Payout Changes and Announcements tool to find an updated list of companies that recently announced changes in their payout policies, along with their ex-dividend dates.

From the perspective of income investors, dividend payouts create far more value than share repurchases. Whereas buybacks usually work in favor of the company, dividend payouts offer more flexibility for the investor by giving them the choice to collect cash or buy more shares. Dividend payouts also signal confidence and stability in the underlying business model. After all, corporations that pay dividends regularly are confident in their future cash flows.

Consider the case of Dividend Aristocrats that represent companies that have grown their payouts for at least 25 consecutive years. These are among the healthiest and most stable when it comes to cash flows. Companies like 3M (MMM ), Coca-Cola Co (KO) and Johnson & Johnson (JNJ ) have grown their dividends for at least 54 consecutive years. These companies are also part of the Dow 30, an enviable list that features some of America’s foremost blue-chip stocks.

From a management perspective, dividends have one major drawback: they are considered sticky. With regular dividend payments, there is a tradition of maintaining or increasing the payout. A failure to do so may trigger market backlash, which could make the stock less appealing in the long run.

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For income investors, share repurchases offer very little benefit. Dividends, on the other hand, entice long-term investment in the company. In this scenario, the company benefits from a stable shareholder base while investors capitalize on a more profitable portfolio.

Below is a summary of key reasons why dividend payouts are more effective from an investor’s perspective:

• Flexibility: Whereas share repurchases offer flexibility for the corporation, dividend payouts give investors the option of expanding their holdings or reinvesting earnings into the company.

• Readily Available Cash: Flexibility extends far beyond reinvestment potential. Under a dividend payout structure, investors can collect cold hard cash.

• Shareholder Return: When a company pays dividends, all shareholders get paid out. This isn’t the case for buybacks, which are self-selected. This means that only those shareholders who tender their shares back to the company receive cash.

• Management Discipline: Under a dividend payout scheme, corporations are prevented from retaining too much cash. Having too much cash on hand often results in foolish ventures or poorly thought-out acquisitions. Dividend payouts instead focus on keeping shareholders happy.

• Share Count: When a company pays a dividend, the overall share count is unaffected. This isn’t the case in a repurchase, where the overall share count declines by the number of shares bought back.

Do you want to know why companies pair dividend payouts with share repurchases? Click here to find out.

Although stock repurchases have their time and place, they offer little value for income investors. Dividends benefit both shareholders and companies by establishing a consistent payment structure, which encourages more capital to flow into the company. For investors themselves, dividends are a sensible way to generate income without the added risk.

Stay up to date with next week’s major corporate changes regarding dividends in our News section on Dividend.com.