Historical Shift Away from Cash DividendsThroughout the history of organized capital markets, investors as a whole seemed to believe that companies existed solely for the sake of generating dividends for the owners. After all, investing is the process of laying out money today so that it will generate more money for you and your family in the future; growth in the business means nothing unless it results in changes in your lifestyle either in the form of nicer material goods or financial independence. Certainly, there was the odd exception Andrew Carnegie, for example, often pushed his Board of Directors to keep dividend payouts low, instead reinvesting capital into property, plant, equipment, and personnel. Some high profile privately owned family firms have had near cataclysmic schisms over the dividend policy; often you have those involved in the day to day operation of the business on the one hand who want to see the money go into funding growth, and on the other, those who simply want larger checks to show up in the mail.
In recent decades, a fundamental shift away from dividends has developed. Partly responsible is the U.S. tax code, which charges an additional 15% tax on dividends paid out to shareholders (before the Bush administration, this tax was as high as the graduated income tax in some cases exceeding 35% on the federal level alone). Combined with the enactment of rule 10b-18, passed by Congress in 1982, protecting companies from litigation for the first time, widespread repurchases could be undertaken without fear of legal consequences. As a result, many high profile Board of Directors made the decision to return excess capital to shareholders by repurchasing stock and destroying it, resulting in fewer shares outstanding and giving each remaining share a larger percentage ownership in the business. Consider that in 1969, the dividend payout ratio for all companies in the United States was 55%. In April, 2000, the S&P 500 dividend payout ratio hit an all-time low of 25.3%, according to the newly revised edition of The Intelligent Investor. More recent statistics tell an even clearer story: According to Standard and Poors, in fiscal 2005, the S&P 500 generated net income of $634 billion and paid cash dividends of $201.84 billion on a market value of approximately $11 trillion. One estimate by Legg Mason shows that share repurchases for the year approximated an additional $250 billion, resulting in a total return to shareholders of roughly $451 billion, or 71% of earnings.
Two Major Advantages to Share RepurchasesShare repurchases are clearly a more tax efficient way to return capital to shareholders because there is no additional tax on buy backs even though your pro-rata equity in the enterprises increases, resulting in potentially more profit and cash dividends on your shares even if overall sales or profits never increase. There is one problem, however, that can undermine these results, rending repurchases far less valuable:
- If the share repurchases are completed when a companys stock is overvalued, shareholders are harmed. It is, in effect, the same as trading in $1 bills for $0.75, destroying value.
- If large stock options or equity grants are issued to employees and management, the repurchases will, at best, neutralize their negative impact on diluted earnings per share. The actual number of shares outstanding wont decrease. In this case, the share repurchases are merely a clever guise for transferring money from the shareholders to management.