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The New Dividend

The once mighty dividend isn't what it used to be. Although dividends have regained some popularity, they remain largely supplanted by share buybacks with nearly half of all corporate distributions going to repurchase shares. Like dividends, buybacks represent a return of shareholders' equity but they have their own unique characteristics.

A share buyback occurs when a company repurchases and cancels its shares. The process sounds simple but it can have far-reaching implications. After all, decreasing the number of shares outstanding changes many commonly used fundamental figures. Let's use tobacco giant Altria (NYSE:MO) as an example. In 1993, Altria had 2,633 million shares outstanding and, after a series of buybacks, it had only 2,111 million shares in 2002. Over the same period, Altria's net income rose 259.2% from $3,091 million to $11,102 million. The company's already impressive income growth becomes even greater when converted to earnings-per-share. If Altria had not repurchased its shares it would have posted earnings-per-share of $4.22 in 2002. However, due to its share buybacks, Altria earned $5.21 per share last year which represents a 285.9% increase since 1993. Naturally, any per-share figure will increase as the number of shares decreases.

It is important to remember that balance sheet figures will also be impacted when cash is used to buy and then retire shares. Share buybacks have the effect of decreasing current assets when the shares are purchased and decreasing shareholder equity when the shares are cancelled. The resulting decrease in shareholder equity puts upward pressure on return on equity which is calculated by dividing net income by equity. In Altria's case, its return on equity increased from 25.6% in 1993 to 56.8% in 2002. Firms can run into trouble when buying back equity because debt remains constant while equity decreases which increases the firm's leverage. Increased leverage ratios can lead to lower debt ratings which usually increase a company's borrowing costs. Additionally, highly leveraged firms have little margin for error and slight downturns can be magnified into possible bankruptcy. Fortunately, in Altria's case, asset growth exceeded debt growth and the company's debt-to-equity ratio remained within a reasonably narrow range.

Another problem with share buybacks is that they often replace dividend increases and they are not nearly as stable as regular dividends. Investors keep close track of dividends and expect them to stay the same or grow. A dividend cut is seen as disgraceful and is usually a sign of economic weakness. As a result, shareholders often punish the stock of companies that reduce their dividend. Canadian dividend investors may still remember the drubbing that TransCanada Pipelines (TSE:TRP) received when it cut its quarterly dividend from $0.28 per share to $0.20 per share. Speculation of the possible cut, and the cut itself, took TransCanada's shares from $15 per share down to a low of $6.75 per share. On the other hand, share buybacks are not followed nearly as closely and are not expected to be regular. As a result, management can more easily stop share buybacks than it can stop paying dividends which makes share buybacks less certain.

Share buybacks can also displace dividends due to purely selfish reasons. The abuse of stock options given to management has been much in the news during the last few years. So much so that investors can be excused for thinking that we've moved from an era of robber barons to an era of robber CEOs. The huge quantity of cheap options provided to management in the 1990s put pressure on dividends because the options become less valuable as dividends are increased. How does this work? Consider a stock that trades for $50 and an option on the stock that can be exercised at $40. If the manager were to exercise the option it would be worth $10. However, if the company pays a dividend of $2 then the stock is likely to fall to $48. In this case, the manager's option would be worth only $8 after the dividend. A decline of 20%! Most people don't want to lose 20% and you can bet that managers in this situation would not be keen on increasing the dividend to $3; quite the opposite, option-oriented managers would much rather decrease dividends. Share buybacks, on the other hand, help option-oriented managers because they tend to increase share prices and make options more valuable. Not surprisingly, the rise of management options has corresponded to a decline in dividend yield (See Figure 1). Interestingly, the average firm continues to pay about 25% of profits to shareholders but the form of the distribution has shifted from mostly dividends to about half dividends and half share buybacks.

Figure 2

Despite the mischief that can be caused by option-focused managers, stock buybacks are an excellent way to return money to shareholders. With half of modern 'dividends' being paid in the form of buybacks, investors should keep an eye on both buybacks and dividends. With this in mind, I investigated the thirty companies in the Dow to find firms that decreased their share count from 1993 to 2002. I further narrowed down the list by discarding companies with debt-to-equity ratios of more than 1.5. Of the thirty Dow stocks only the twelve shown in Table 1 passed both tests. For these twelve stocks I determined the average annual percentage of shares that were repurchased from 1993 to 2002. I then added this buyback percentage to the stock's current dividend yield to find a total yield. The list in Table 1 is sorted by total yield and several stocks appear much improved on a total yield basis. As with dividend yield, the total yield can only be sustained by firms with sufficient earnings. Any stock with an earnings yield that is less than the total yield is in uncertain territory. Also, stocks with total yields larger than long-term bond yields usually have some form of hidden risk. For instance, Altria is exposed to tobacco-related litigation risk. Nonetheless, many Dow stocks trade at attractive yields when compared to short-term government bonds and are worth consideration by investors.

Table 1: High yield DOW stocks
Stock PriceBuybackDividend YieldTotal YieldEarnings Yield
Altria (MO)40.002.43%6.10% 8.53%12.8%
Eastman Kodak (EK)26.601.32%6.70%8.02%9.3%
DuPont (DD)41.963.38%3.30%6.68%4.6%
30 Year US Government Bond4.90%
IBM (IBM)86.743.08%0.70%3.78%3.6%
3M (MMM)127.621.18%2.00%3.18%4.0%
5 Year US Government Bonds2.75%
Procter & Gamble (PG)88.580.53%2.05%2.58%4.1%
Merck (MRK)61.73 0.27%2.30%2.57%5.2%
Coca-Cola (KO)42.910.55%1.90%2.45%3.8%
McDonald.s (MCD)21.121.23%1.00%2.23%3.7%
United Tech (UTX)72.190.73%1.40%2.13%6.3%
Wal-Mart (WMT)56.650.36%0.60%0.96%3.2%
Intel (INTC)25.310.65%0.30%0.95%2.2%
Source:,, July 16 2003

Although dividend yields are declining, dividend oriented investors should take heart because much of the slack is being taken up by share buybacks. Share buybacks are a little more difficult to keep track of, and not nearly as certain as dividends, but they represent good value to shareholders.

Disclosure (09/01/03): Altria is currently my largest public stock holding.

First published in September 2003.

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