There are few topics more divisive among income investors than the question of whether dividends or share buybacks are the superior wealth generator.
Where once the humble dividend was the favoured means of returning cash to shareholders, these days companies are turning in increasing numbers to buying back their own stock in the market or direct from investors, often as a (theoretical) means of boosting earnings per share (EPS). Regardless of how you view the issue, the fact that many companies now pay dividends AND routinely buyback shares means that traditional metrics for comparing income stocks have become deficient in some circumstances. What’s needed is a new solution.
Dividends vs. Buybacks
The debate over dividends vs. buybacks is an in depth affair (and one for another day) but the rough guide goes something like this…
While dividend payouts are at the top of the priority list for income investors – who use metrics like dividend yield, growth and cover to screen the market for potential stock candidates – share buybacks meanwhile, present a few uncertainties.
On the plus side, a company with excess cash can act to increase its EPS simply by buying up its own stock at less than intrinsic value and reducing the number of shares in issue. On paper, that looks like a great idea because a buyback has the effect of spreading a company’s profits between fewer shares, meaning that the share price should respond accordingly.
However, critics point to the fact that management incentive schemes are frequently linked to EPS performance, which, they argue, can unduly influence the decision to launch a buyback scheme. In turn, detractors have stressed that even management teams can be poor at determining the price at which a buyback represents good value. In 2011, for instance, Home Retail (LON:HOME), the group behind the Argos and Homebase retail chains, spent 12 months and £150 million buying back shares at well over 230p (and occasionally as high as 270p) but its shares have since fallen to around 77p.
A further criticism of buybacks is that companies can (and do) continue to issue shares even when they are buying back stock in the market – for example, when they need to cover stock options. If the net effect is that more shares are issued than bought back, then the EPS-boosting effects of buybacks can be damaged and existing shareholders can ultimately end up diluted.
While the critics of buybacks are a vocal bunch, some of the most vociferous supporters have been running very successful UK companies. One of the most prominent examples is High Street fashion retailer Next (LON:NXT), which launched a buyback programme in March 2000 in a deliberate effort to enhance EPS over the long-term. Since then it has returned over £2.6 billion to shareholders by way of share buybacks as well as almost £1.2 billion in dividends. Meanwhile, one of the most popular FTSE 100 income stocks is telecoms giant Vodafone (LON:VOD), which currently boasts a forward dividend yield of 8.09 percent. But that is only part of the story because Vodafone has been buying back its shares for several years, particularly as a means of distributing the gains made on asset disposals. Of the £14.8bn it has raised from disposals since September 2010, £6.8bn has been committed to a share buyback programme that is now majority complete.
Figuring out the Payout
So how can income hunters adapt to this new landscape where companies distribute returns in different ways? While the dividend yield has traditionally been used as a key measure in rating dividend-paying stocks, economists and academics have also long used the ‘total payout ratio’, which adds together the dividends and buybacks and divides it by net income. What that doesn’t deal with however, is the thorny issue of further stock issues.
To tackle that, we need a formula first proposed in a 2004 paper by US researchers Boudoukh, Michaely, Richardson and Roberts, who agreed that the total payout yield – or the combination of dividends and buybacks – was superior predictor of equity returns than simply using the dividend yield. Taking that ratio a step forward and including the effects of any share issuances (they called it the Net Payout Yield) offered even more startling returns.
The ratio adds together the amount spent on dividends and buybacks minus any cash collected from the issue of new stock. That figure is then divided by the company’s market cap. In his book, Your Next Great Stock, US investment commentator Jack Hough highlighted the impressive academic findings behind the Net Payout Yield. Between mid-1983 and the end of 2005 the dividend-only Dogs of the Dow screen returned 16.2 percent – beating the Dow Jones industrial average by 3 percent per year. Using the Net Payout Yield rather than the dividend yield would have returned 19.1 percent per year.
Balking at Buybacks
Despite the perceived logic of combining dividends and buybacks as a measure of income stocks – and the academic and empirical findings that support it – the Net Payout Yield isn’t yet a mainstream metric in the UK (it enjoys much more fame in the US). Arguably, limited awareness and scepticism among investors of the value (or otherwise) that buybacks actually achieve (and the reasons why management teams initiate them) is a deterrent. Nevertheless, with buybacks becoming an increasingly common occurrence, income investors would be crazy to cut them out of the valuation equation.