Michael Mauboussin: Thoughts On Dividends And Buybacks – Clearing Up Some Common Misconceptions

H/T Dataroma

Michael Mauboussin is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press, 2012), Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press, 2001).

Visit his site at: michaelmauboussin.com/

Michael Mauboussin: Thoughts On Dividends And Buybacks – Clearing Up Some Common Misconceptions

Michael Mauboussin Dividends And Buybacks

“Our study provides theoretical and empirical evidence for a total payout (dividends plus buybacks) model of stock returns.” – Philip U. Straehl and Roger G. Ibbotson

  • The conventional wisdom that dividends make a crucial contribution to accumulated capital over time is wrong.
  • Very few investors actually earn the total shareholder return because it demands that they fully reinvest all dividends.
  • You commonly hear complaints that companies buy back stock at prices that are too high and thus “destroy shareholder value” or “waste money.” This is a simplistic assessment that confuses two issues.
  • There is a value conservation principle associated with buybacks. The value of a firm declines by the amount of capital it disburses. Buying back shares that are over- or undervalued creates offsetting winners and losers.
  • If you own the shares of a company buying back stock, doing nothing is doing something. That something is increasing your percentage ownership.


The value of a company is determined by the cash that it pays to its owners over its life. A firm can return capital to shareholders through dividends, share buybacks, or by selling the company for cash. Ultimately, value boils down to cash in the pocket. Empirical evidence supports the theory.

Companies in a position to pay a dividend or to buy back stock have to weigh those alternatives against investing the money back into the business. The idea is that an attractive internal investment will allow the company to return even more money in the future, adjusted for risk and inflation, and will therefore enrich current investors. Most investors agree on these points. Appendix A examines the concern that companies today are underinvesting in their businesses.

The relative merits of dividends, buybacks, and investment are contentious. Share buybacks, in particular, seem to stir emotion, much of it negative.2 The purpose of this report is to address a handful of

  • Dividends are the major contributor to capital accumulation over time;
  • Buybacks destroy value or waste money;
  • Shareholders can be passive with regard to share buyback policy.

Price Appreciation and Dividends

Investment managers and pundits often make the claim that dividends are the primary source of total shareholder return over the long haul.3 But it is crucial to distinguish between the equity rate of return for one year, which is simply the change in the stock price plus the dividend, and the capital accumulation rate, or total shareholder return (TSR) over time. The central difference is that total shareholder return incorporates the reinvestment of dividends. As a result, these are very distinct concepts.

For example, a stock that has price appreciation (g) of 7 percent with a dividend yield (d) of 3 percent in a given year has an equity rate of return of 10 percent. But if the g and d remain constant over time, the total shareholder return is 10.21 percent, based on this formula:

????? ??????????? ?????? = ? + (1 + ?)?

Once you appreciate this distinction, you can see that “price appreciation is the sole source of investment returns that increase accumulated capital.”5 This quotation comes from Alfred Rappaport, a professor emeritus at the Kellogg School of Management at Northwestern University, and it surprises even experienced investors. The conventional wisdom is that the income component makes a crucial contribution to accumulated capital and that its contribution grows over time. This is wrong.

To see why, let’s slow things down and again distinguish between the equity rate of return and total shareholder return. We’ll use a $100 stock and the same g of 7 percent and d of 3 percent.

If you consider results for one year, it is pretty simple. You start with an investment of $100 and end the year with a stock worth $107 and $3 in cash. You begin with $100 and end with $110 for a 10 percent return. So far, so good.

Now let’s go to the total shareholder return case. The TSR calculation makes the crucial assumption that 100 percent of dividends are reinvested in the stock. So if at the end of the year you have a $107 stock and a $3 dividend, you use the cash dividend to buy more stock, getting your investment in the stock back up to $110. Once you make the decision to reinvest all of your dividends, it becomes clear that capital accumulation depends entirely on the price change over the time you invest.

The key to understanding TSR is that it is a measure over multiple periods. In year two, the stock rises to $117.70 and the dividend is $3.30, yielding a total value of $121. The dividend is again reinvested in the stock, meaning that you have $121 in stock at the end of two periods. The process repeats.

Very few investors actually earn the TSR because it demands that they fully reinvest all dividends. In reality, many investors choose to spend their dividends. This has utility for those investors, of course, but prevents them from earning the TSR.

Further, because the government taxes dividends, investors in a taxable account cannot reinvest the full amount of their dividends. For companies that pay a dividend, only investors who reinvest 100 percent of their dividends in a tax-free account actually realize the TSR. This is a very small percentage of the investing population. Indeed, the value of the stock market rises at a lower rate than the market’s TSR as investors and governments extract value along the way.

Saving is the act of deferring current consumption in order to consume more in the future. Investors save to fund retirement, pay for education, or to ensure that an institution such as a university can thrive in the future. In each case, the investor cares about capital accumulation.

For equities, price appreciation is the only source of investment return that increases accumulated capital. The reason is that an investor makes an investment decision to reinvest the dividend into the stock. Say you own a stock that trades at $100 and declares a $3 dividend. The day the dividend is paid, you have a stock worth $97 and cash of $3.7 You must put the $3 back into the stock to earn the total shareholder return.

The Value Conservation Principle

You commonly hear complaints that companies buy back stock at prices that are

1, 2  - View Full Page