Dividends vs Buybacks: What's the Difference and What's Better for a Long Term Investor

The age-old debate of buybacks and dividends has puzzled investors for decades. While some investors swear by the steady income provided by dividends, others tout the potential capital gains from buybacks. In general: how many investors, so many investing preferences.

But is one approach truly better than the other? In this blog post, we’ll take a fresh perspective on this debate by comparing the two based on various factors and showcasing real-life examples of successful dividend and buyback strategies. Let's check out, which one would be better for your further growth!

Understanding Dividends and Buybacks

Dividends and buybacks are two approaches companies use to return capital to shareholders. Dividends are cash or stock payments made to shareholders, reflecting a company’s profitability and financial health. Buybacks, on the other hand, involve a company repurchasing its own shares, reducing the number of outstanding shares and potentially increasing their value. The ongoing discussion revolves around which is preferable in the stock market: dividends or buybacks.

While both dividends and buybacks can provide shareholders with long-term value, they serve different purposes. Dividends are more advantageous for generating income, whereas buybacks are more oriented towards enhancing capital growth, which can result in lower capital gains tax for investors.

Dividends: Definition and Purpose

Dividends are a portion of a company’s profits distributed to its shareholders at regular or special intervals. They can be indicative of a company’s profitability and financial health, and the dividend yield can be an important metric for investors to consider. Dividends serve as a means to maintain shareholders’ interest in their stock and to return excess cash to investors.

Special dividends are one-time dividend payment distributed to shareholders by a company. The value of shares may increase as investors and traders acquire the stock in anticipation of dividends and appreciation in price, especially when the company buys back its own shares. However, a decrease in net income typically results in a corresponding reduction in dividend payments.

Investors who receive dividends have the flexibility to decide how to utilize the funds. Cash dividends offer investors a regular stream of cash, which may be a motivating factor for those dependent on their investments to cover their living costs. When a company begins to pay dividends, it is indicating that it is generating sufficient income to share some of it with its shareholders. Conversely, when a company cuts its dividend, this is typically viewed as a negative indicator, resulting in a decline in share price and a decrease in investor confidence. This regular stream of cash is especially important for all sorts of Pension Funds and individual annuitants - in a word, for wealthy entities looking for a stable source of income.

A Share Buyback: Definition and Purpose

A share buyback refer to a company repurchasing its own shares. The reason why company buys share buybacks is to:

• Reduce the number of outstanding shares
• Potentially increase their value
• Prove advantageous if the stock is not projected to grow further or if the company may discontinue dividends
• Potentially result in long-term capital gains for many investors
• Increase the stock value during and after the repurchase.

Shareholders may gain valuable profits from this, and buying back shares is a frequently utilized technique to artificially elevate earnings per share (EPS). However, each share buyback should be undertaken with caution and not for any ulterior motive or to mislead stakeholders.

The process of getting share buyback can be quite taxing and expensive. Chains of filings and approvals from stock exchanges have to be completed. Share repurchases can indicate to investors that the company has ample cash reserves and is unlikely to be affected by economic downturns.

Dividend or Share Buyback: Comparison

Let’s examine dividends and buybacks by assessing the benefits to investors, tax considerations, and their influence on company performance. Understanding these factors can help investors make informed decisions about which approach is better suited to their investment goals, preferences and expected future returns.

Investor Benefits

It’s important to note that dividends offer investors a reliable source of income in addition to the potential for capital growth. Since dividends are paid out regardless of the company’s performance, they provide investors with a sense of assurance. On the other hand, buybacks offer investors the potential for capital growth, as the company is purchasing its own stock, which may enhance the worth of the outstanding shares. Additionally, buybacks grant investors a sense of assurance, as the company is investing in itself.

Historically, cash dividends have contributed significantly to an investment’s return. Standard & Poors data indicates that since 1926, dividends have accounted for approximately one-third of total returns for U.S. stocks.

Tax Implications

Dividend payment is typically taxed at a rate lower than other forms of income, such as interest or capital gains. This tax advantage can make dividends an appealing option for income-focused investors. However, it’s essential to be aware of the specific tax rules and regulations in your country or region, as they can vary significantly.

In contrast, buybacks are generally not subject to taxation, as the company is repurchasing its own stock. This can make buybacks a more tax-efficient way of returning capital to shareholders, especially for those looking to minimize their tax liabilities. However, investors should consult their financial or tax advisors to understand the tax implications of buybacks, as tax rules and regulations can vary by country or region.

However, you can't forget that dividends are taxed twice - first the company pays tax on its profit, then what's left pays out to them as dividends, and then the investor pays tax on the dividend. In this arrangement, the same money is taxed twicely, which may not be the best use of the money earned by the company....

Impact on Company Performance

Paid Dividends can have a beneficial effect on company performance, as they can attract new investors and indicate to existing investors that the company is performing well. Similarly, buybacks can have a beneficial effect on company performance.

Both dividend payouts and buyback strategies can signal financial stability and a commitment to shareholder value, making them attractive options for investors.

The Role of Dividends and Buybacks in Long-Term Investing

The focus of this section is on the role of dividends and buybacks in long-term investing, specifically looking at dividend-paying stocks and stocks with active buyback programs.

Understanding the benefits and drawbacks of each approach can help investors tailor their investment strategies to align with their long-term goals.

Dividend-Paying Stocks

Dividend-paying stocks can provide the following benefits:

• Consistent income
• Associated with established, financially stable companies
• Regular income stream, appealing for those who rely on investments for living expenses
• Hedge against inflation
• Viable way to diversify a portfolio

Some well-known examples of successful dividend-paying companies include Procter & Gamble paying uninterrupted dividends for 67 years, and Berkshire Hathaway, which has been paying dividends since 1967. By investing in companies with a strong track record of paying and increasing dividends, long-term investors can benefit from both income generation and potential capital growth.

Stocks with Active Buyback Programs

Stocks with active stock buybacks can offer potential for capital appreciation and increased shareholder value. Companies that repurchase their own shares can reduce the number of outstanding shares, which can result in higher earnings per share and a higher return on equity.

Some examples of successful companies engaging in buyback investing include Apple, Microsoft, and Alphabet, who have all repurchased significant amounts of their own shares. By investing in stocks with active buyback programs, investors can benefit from the potential capital appreciation and increased shareholder value that these strategies can provide.

‍Remember: you can easily find companies doing buyback using the Screener in Scrab.com. Note, however, that stock buybacks are not in Scrab as a separate metric - for this purpose, it's best to look at the number of shares (according to the "former buybacks -> shares are fewer" equation).

Factors to Consider When Choosing Between Dividends and Buybacks

In choosing between dividends and buybacks, several considerations are critical, including your investment goals, the company’s fundamentals, and market conditions.

We’ll delve into these factors more deeply, aiding you in making an informed decision about the approach most fitting to your unique investment strategy.

Investment Goals

Aligning your investment goals with the benefits of dividends or buybacks is crucial in determining which approach is right for you. For instance, if your primary goal is income generation, you may prefer dividend-paying stocks, which provide a consistent source of income. On the other hand, if your focus is on capital growth, you may find buybacks to be more appealing, as they can result in an increase in share prices and provide a tax-efficient way of returning capital to shareholders.

Company Fundamentals

Analyzing company fundamentals is vital in determining the sustainability of dividends or the effectiveness of buyback programs. Investors should examine the company’s cash flow, earnings, and debt levels to gauge its ability to distribute dividends or engage in share buybacks.

It's worth noting that there have been instances in history of companies getting into debt to maintain dividends - taking out a loan to pay this borrowed money to investors. They had to do this in "hard times" in order not to lose their status as dividend aristocrats, because then a lot of dividend ETFs and funds would have had to divest that company from themselves, which in turn would have resulted in a big sell-off. That's why it's important to see if the company actually has the money for dividends, or if it's bailing out with debt, increasing the chance that dividends will run out in the near future.

For dividends, it is essential to consider the company’s dividend history, payout ratio, and financial health. For buybacks, investors should evaluate the company’s stock price, earnings per share, and return on equity to determine the effectiveness of the buyback program.

By understanding the company’s fundamentals, including the company’s earnings, you can better assess the potential benefits and risks associated with dividends or buybacks when the company pays.

Market Conditions

Considering market conditions is crucial when deciding between dividends and buybacks, as they can have a significant impact on both strategies. Evaluating factors such as interest rates, inflation, and stock prices can help you determine whether a dividend or buyback strategy is better suited to the current market environment.

For example, in a bullish market, companies may be more inclined to pay out dividends or initiate buyback programs, while in a bearish market, companies may be more likely to reduce or suspend dividend payments or buyback programs. By understanding the prevailing market conditions, you can make more informed decisions about whether dividends or buybacks are the better option for your investment strategy.

Example? In modern tools to improve stock picking, you can easily see what a particular company did during the recession - did it withhold/reduce payouts? A decision supported by this knowledge will be significantly more accurate.

Real-Life Examples of Dividends and Buybacks

To provide a clearer picture of the potential benefits of dividends and buybacks, we will examine real-world examples of successful dividend and buyback strategies. These success stories can provide valuable insights into the advantages and potential drawbacks of each approach, helping you make more informed decisions about your investment strategy.

Dividend Payments: Success Stories

Dividend success stories highlight companies that have consistently paid and increased dividends, benefiting long-term investors. For example, Coca-Cola has been paying a quarterly dividend since 1920 and has had a consistent record of dividend increases for over 60 years. Another example is Warren Buffett, who has built a successful portfolio with over 90% of his investments in dividend-paying stocks.

These success stories demonstrate the potential benefits of investing in dividend-paying stocks. By choosing companies with a strong track record of paying and increasing dividends, long-term investors can benefit from both income generation and potential capital growth.

Buyback Success Stories

Buyback success stories demonstrate how companies have effectively used buybacks to increase shareholder value and improve financial performance. For example, Apple Inc. has been repurchasing its own shares since 2012 and has augmented its buyback program annually since then. Similarly, Berkshire Hathaway has been buying back its own shares since 1967 and has augmented its buyback program annually.

These success stories showcase the potential advantages of buybacks for investors, such as capital appreciation and increased shareholder value. By investing in stocks with active buyback programs, investors can benefit from the potential capital appreciation and increased shareholder value that these strategies can provide.

How Scrab.com Can Help you in This Topic?

Remember that your choices can ( and in fact should) be supported by a data-driven approach. At Scrab.com we are at your service - when choosing certain dividends or buybacks you can always take advantage of our dedicated features:

1. Find companies with high dividend yield using Scrab's Screener
2. As above - the screener also works great for  companies with buybacks :)
3. Check the trend for dividend/buybacks (increasing since when, what happens during recessions, how big part of the profits is spent on them, etc.)
4. Automate! Once you decide which type of companies you prefer (or maybe some balance/combination of both?) create scoring model and in seconds find which of the companies from step 1 & 2 match your approach best!

Learn about our payout ratio (screen above) - a metric that shows how much of a profit is earmarked for dividend payments. If too little - the situation is not good, because the company could pay more; if too much it is also bad because the company may not have the money to maintain the level of payouts if business starts to go even a little worse.

Sound interesting? Sign up for our 7-day free trial today!

What to do With Excess Cash?

In conclusion, both dividends and buybacks offer unique benefits for investors and can help them in building wealth.

Dividends provide a consistent source of income and are often associated with established, financially stable companies. Buybacks, on the other hand, are better for investors willing for potential capital appreciation and increased shareholder value. Ultimately, the decision between dividends and buybacks depends on your investment goals, the company’s fundamentals, and the prevailing market conditions (and taxes and whether you need regular cash payouts.

By considering these factors and learning from real-life success stories, you can make more informed decisions that align with your long-term investment strategy and goals.