Dividend Stocks

Investing In Stocks For The Sake Of Cash Flow

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Buying Back Shares vs Dividends

Posted on | May 26, 2011 | Comments Off

Many of the companies in the dividend portfolio engage in both buying back shares and paying dividends.  There’s a constant argument about what might be the better strategy and what is better for shareholders.  The answer to that really depends.

Before we begin, the problem with share buybacks is that sometimes management uses them to reverse the dilution that occurs with granting stock options to executives in the company.  The executives exercise their options and it dilutes the shares.  Later on, the management uses cash on the balance sheet to buy these same shares back.  I hate this practice, and you should definitely look into all companies you’re considering investing in with regards to this practice.

Now, buying back shares can have a material impact on the number of outstanding shares of a company.  For instance, examine the following chart of the number of outstanding shares of Wal-Mart (WMT) over the last ten years.  You can see a decline from approximately 4.5 billion shares to 3.5 billion shares in the time span.

This does have a positive impact on EPS since there is essentially more earnings to go around fewer shares.

Now, is this a good use of cash? It depends on the level which the share are bought. In the case of Walmart, I don’t think it’s that bad since the shares have been sort of stagnant. Same could be said for a Microsoft which hasn’t budged for some time.

The reality is that if management can generate a great return by buying back shares, then it’s a good use of money. If instead they are buying back shares to try and continue to prop up a stock that has had a huge run, they are in the wrong in many ways. First, their focus shouldn’t be to temporarily prop up a stock, and second, they’re likely buying back shares at an artificially high level which will end up with a negative return.

For the most part, I prefer dividends over share buybacks, but realize in today’s world, companies are going to buy back shares. We just hope management’s goals are for high rates of return on invested capital versus trying to manipulate the stock or mask high levels of stock option grants.