The Economics of Buybacks

Why are dividend yields so low despite record corporate profits? You need look no further than "share buybacks" -- stock repurchased by the very firms that issued it. Last year,companies in Standard Poor's 500-stock index repurchased a startling $349 billion worth of their own shares, or 70% more than they paid out as cash dividends. So the question is whether this is a good thing for investors in these companies.

Generating value

In a nutshell, yes. Let's review how companies can use their earnings. The first is to pay cash dividends, the time-honored method of sharing profits with the owners. The second is to reinvest the cash in the company, in hopes of generating greater profits. The third is to use the cash to buy back shares.

Buybacks benefit shareholders by boosting per-share earnings. To compute earnings per share you use the number of shares outstanding, excluding shares repurchased. Because stock repurchases reduce the shares outstanding, per-share earnings can rise even if total profits remain unchanged. If profits do rise, per-share earnings go up even more.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Which of these ways of creating value is best for shareholders? Cash dividends generally are at the top of the list. They're money in your pocket. Repurchases have one advantage over dividends: Capital gains created when shares are bought back are not taxed until you realize those gains. Because long-term capital gains and dividends are now taxed at the same 15% maximum rate, the deferral of capital gains gives buybacks a slight tax advantage.

But stock buybacks, unlike dividends, do not require the same level of commitment from management to return profits to shareholders. If a firm cuts its dividend, the stock price plunges because this signals a long-term deterioration in the firm's ability to generate profits. In contrast, firms often fail to follow through with planned share repurchases. So investors do not attach nearly the same importance to management's reneging on its share buybacks as they do to a cut in the dividend.

Despite the advantages of dividends and buybacks, many argue that a return of profits to investors is a sign that the company has nothing better to do with its money. They'd rather see earnings used to generate even greater future profits. But realistically, that isn't always possible. Sometimes, giving money back through dividends or buybacks is the best possible course. The past decade was filled with sad tales of firms that squandered profits to purchase overvalued companies, seeking synergies that never materialized, or expanding into markets where they had no special advantage.

In fact, following up on a study by Morgan Stanley, I investigated the relationship between a firm's capital spending and investor return by sorting the companies in the SP 500 by the size of their capital outlays relative to sales.

The results put to rest claims that capital spending is the foundation of good stock returns. The returns to investors from those firms with the lowest ratio of capital expenditures to sales outperformed those with the highest ratios by more than five percentage points per year.

I am not saying that all companies that use their profits to finance growth are harming their shareholders. But often management is afflicted with the same temptation as we ordinary individuals: When you have cash, you spend it.

Get to like it

So don't avoid companies that actively repurchase their shares. The surge in stock buybacks represents a more disciplined use of profits than in the profligate 1990s and boosts per-share earnings and stock prices. It may be better for management to pay cash dividends, but shareholders benefit when profits are returned in either form.

Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and author of Stocks for the Long Run and The Future for Investors.