Michael Mauboussin: Thoughts On Dividends And Buybacks – Clearing Up Some Common Misconceptions
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).
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Michael Mauboussin: Thoughts On Dividends And Buybacks – Clearing Up Some Common Misconceptions
“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:
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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 too high and thus “destroy shareholder value” or “waste money.”8 This is a simplistic assessment that confuses two issues.
The first issue is what happens to the value of a firm when it pays out capital. Say a company is worth $1,000 and it chooses to pay out $200 to its shareholders. It should be obvious that the value of the firm following the disbursement is $800. Indeed, it doesn’t matter whether the company pays a dividend, buys back stock, or donates the $200 to a charity. The value of the firm adjusts accordingly.
The second issue is the plight of the ongoing versus selling shareholders. If a company buys back stock that is overvalued, the sellers benefit at the expense of the continuing shareholders. If a company buys back stock that is undervalued, the ongoing shareholders benefit at the expense of the selling shareholders. All shareholders are treated the same if a company pays a dividend or buys back stock at fair value.
The important point is that there is a value conservation principle: the winners and the losers offset one another.9 It is true that ongoing shareholders suffer if a company buys back stock at $50 per share and it subsequently drops to $30. But you can’t forget that the sellers at $50 made out well.
Here is another point to consider if you are a fan of dividends. If you agree that buying back undervalued shares adds value for ongoing shareholders and you believe your portfolio contains undervalued stocks, why would you ever want one of your holdings to pay a dividend? As Warren Buffett, chairman and chief executive officer of Berkshire Hathaway, has written, “Indeed, disciplined repurchases are the surest way to use funds intelligently: It’s hard to go wrong when you’re buying dollar bills for 80¢ or less.”
Doing Nothing Is Doing Something
Imagine you were a shareholder of a company that paid a dividend when the stock was at $50 and then it subsequently dropped to $30. Would you have any complaints about the dividend? Now imagine that you were a shareholder of a company that repurchased shares at $50 (you did not sell) and then the stock slumped to $30. How would you feel?
Chances are you would not have any complaints about the dividend. Indeed, the dividend you received might soften the psychological blow of the steep price decline.11 But you would likely be irritated by the inopportune buyback. This is despite the fact that you own the stock because you found it attractive at a higher price.
If you rewind the situation with the buyback, it is easy to see that you could have sold a prorated number of shares that would have resulted in a homemade dividend and the same percentage ownership in the company. This leads to an important point: if you own the shares of a company buying back stock, doing nothing is doing something. That something is increasing your percentage ownership in the company.
Some of the misgiving about buybacks is well placed, as companies pursue them with multiple motivations. The fair value school takes a steady and consistent approach to buybacks. The intrinsic value school seeks to buy back shares only when management deems them to be undervalued. But perhaps the largest group is the impure motives school, which seeks to boost accounting numbers or offset dilution from compensation plans.12 Research shows that there is no correlation between share repurchase intensity, measured as the difference between the growth in net income and earnings per share, and TSR.
Investors must be diligent in assessing management’s motivation for its buyback program and need to recognize the consequences of inactivity when companies do buy back shares.
The value of a business is the present value of future cash flow disbursed to the owners. Appendix B summarizes the details of buybacks and dividends for the S&P 500 Index in 2015 and shows the long-term trends in spending. The primary mechanisms to return cash to shareholders are dividends and share buybacks. Yet there is a great deal of muddled thinking about the role that dividends and buybacks play in building wealth.
In spite of claims that dividends contribute substantially to long-term TSR, price appreciation is the only source of investment return that increases accumulated capital. The key is to recognize that TSR is a multi-period measure that assumes dividends are fully reinvested in the stock. Because investors commonly use dividends to consume and dividends are frequently taxable, a small minority of shareholders earn the TSR.
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.
Only if a stock is at fair value, a nebulous concept itself, do buybacks and dividends have the same impact on all shareholders (leaving aside tax issues).
Companies buy back stock for a host of reasons, and not all of the motivations are economically sound. Shareholders must assess management’s reasoning for buybacks. Finally, if you own the shares of a company buying back stock, doing nothing is doing something. You are increasing your stake in the business and foregoing the opportunity to create homemade dividends.
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