Dividends Vs Buybacks Is WRONG...You Need BOTH!
I'm not against buybacks. I view them as something of a necessary evil.
I'm a dividend investor. That doesn't mean I think it's desirable to have a payout ratio that leaves no margin of safety.
A company might have a return on equity of 25%, but that doesn't mean that by retaining all earnings the company will find 25% growth achievable in the real world.
By paying out some in dividends and spending some on buybacks, it can lower its sustainable growth rate to a more realistic figure...and, of course, the company has a lot more flexibility with the money being spent on buybacks.
Now, if you take either one of those two things away, that return on equity will decrease to the amount of growth achievable in the real world.
That return on equity is the return on shareholder's money.
(1 - Payout Ratio) X Return On Equity = Sustainable Growth Rate.
A dividend drops the sustainable growth rate figure, but usually not enough. After the dividend, the rate we're left with is often still too high to be attainable as a realistic rate of long-term expansion.
My last CAPS pick, Hasbro, has a return on equity of 28%. Its payout ratio is 39%.
(1 - 39%) X 28%...= 17%.
With only the dividend, the sustainable growth rate formula yields a figure that's still over 17%.
Hasbro is a $4.5B company with 5,800 employees. It is already one of the top two companies in its industry. Using the rule of 72 tells us that Hasbro would have to double in size every 4.2 years if it is to grow at 17% annually.
Obviously that probably won't happen. So if we want to maintain a return on equity of 28%, we need to further reduce the other multiple. By using a combination of dividends and buybacks, we can get that sustainable growth rate down closer to a more realistic figure.
Buybacks can help to bring the sustainable growth rate more down to earth.
Some arguments are made in favor of buybacks only. I think that's a mistake.
I believe that quite often buybacks are ultimately used mainly as devices to funnel "dividends" to high-ranking company execs and board members.
Further, I think the old "double taxation" argument is simply too shallow. When I go to work and earn a paycheck, my paycheck comes from customers spending their money. Each of those customers had to pay taxes on the money they're spending...which also, ultimately, came from customers of the business they work for spending money, which was also taxed.
Having the company retain the earnings they would have paid out might seem to be one of the only ways to earn tax-free income, but it will probably exact a price in lowered return on equity.
Again: (1 - Payout Ratio) X Return On Equity = sustainable growth rate.
If either one (dividends or buybacks) is missing, it seems to me as if return on equity must fall.
If the company simply retained earnings, my share of the pie remains unchanged.
Reinvested dividends increase my share of the pie. The argument could be made that the pie will be ever so much smaller, because a dividend could be correctly said to be a debit to book value and a decrease in owner's equity.
Those who reinvest dividends will probably compensate for the decrease in owners' equity that their dividend cost, and they will certainly wind up with a larger piece of the pie than those who take their dividends in cash.
I like to take mine in cash.
The fact that I want my dividends in cash costs the other shareholders nothing except MY share of the profits!
I may or may not reinvest them when the price warrants it. My choice.