Three Major Advantages to Cash Dividends
There are three major advantages to cash dividends that simply aren’t available through share repurchases. They are:
- Psychologically, cash dividends can be enormously beneficial for a shareholder. Imagine, for a moment, a retired school teacher living in a house in the suburbs with a portfolio of $500,000. If she were invested entirely in companies that retained all of their capital and / or repurchased stock, a major market drop of 20%, creating a paper loss, might concern her (it shouldn’t necessarily – for more information read How To Think About Share Prices). If she were to invest in income producing equities with an average dividend yield of, say, 4%, the same loss probably wouldn’t bother her because she would be consoled by the $20,000 cash dividends that arrived in the mail each year. In other words, the distribution of the profit will cause her, knowingly or not, to act more like a business woman acquiring a stake in a private enterprise than a bystander subject to the whims of the stock market. With cold, liquid greenbacks in her hand, she can pay her bills while waiting out the temporary insanity of Mr. Market.
- The need to constantly keep enough cash around each quarter to distribute dividends to stockholders tends to require companies to maintain more conservative capitalization structures, subtly reminding management that they are there to produce wealth for the owners of the business – not just make their empire bigger. It also tends to prevent large cash hoards building up that are inevitably blown by an adrenaline-filled CEO feeling pressure from Wall Street to “do something”. Typically, it seems as if the action of choice is to consummate an expensive acquisition, destroying shareholder value.
- All else being equal, firms that pay cash dividends will not experience as great a percentage decline in bear markets because the dividend yield acts as a protective cushion. Typically, if a well financed, conservatively run business falls so that the dividend is yielding 15%, Wall Street is going to recognize the bargain and snap up the shares. If the cash remained on the balance sheet, investors seem more hesitant to swoop in and take advantage of the situation because there is not guarantee management will allocate the capital wisely.
The Final Verdict on Cash Dividends vs. Share Repurchases
What is the final answer: which is better, cash dividends or share repurchases? Like so many questions, the answer is simply, “it depends.” If you are an investor that needs cash upon which to live or want to ensure that you, rather than management, has the ability to allocate excess profit, you might prefer dividends. If, on the other hand, you are interested in finding a company that you truly believe has the ability to generate large profits by reinvesting in a business that can earn high returns on equity with little on debt, you may want a firm that repurchases shares. Be careful, though, and realize that at the end of the day a company can be extraordinarily successful if the other things are in place, regardless of the total share count. Starbucks, for example, has experienced significant increases in shares outstanding during the time it has been a publicly traded company. Yet, these shares have motivated employees to help build the business and resulted in tremendous profitability and growth for the company’s initial investors. Wal-Mart, on the other hand, has maintained (split adjusted) a fairly steady share count and in recent years has actually decreased the number of shares outstanding while experiencing high growth and paying cash dividends – it stands alone as one of the perfect combinations in Wall Street history.Most likely, a hybrid model will be preferred by directors, such as Home Depot; the home improvement chain has returned over 65% of profits to shareholders in recent years through a combination of aggressive share repurchases and cash dividends. At the same time, it’s increasing its store base and acquiring businesses in the supply side of the industry.
