Dividends and Buybacks Drive Stock Returns

The return of capital by companies to shareholders is a key contributor to long-term returns. A forthcoming study by Morningstar’s Philip Straehl and Yale’s Roger Ibbotson attributes more than two-thirds of the real (inflation-adjusted) return in stock prices for the period of 1871 through 2014 to total yield.

Return of capital includes both dividends and stock repurchases. Dividends, the distribution of cash to shareholders, have a longer history of driving historical stock returns. The increased prominence of buybacks—the repurchase of shares by companies—is attributed to a rule adopted by the Securities and Exchange Commission in 1982. Straehl and Ibbotson found a gradual substitution of buybacks for dividends starting in the early 1980s. They say this shift has resulted in buybacks surpassing dividend payments in eight out of the last 10 calendar years.

Buybacks are not without controversy. Unlike dividends, there is rarely a penalty for a company not repurchasing all of the shares authorized by a buyback program. (CEOs, however, might face the ire of activist investors.) Stock buybacks also can inflate earnings per share growth by simply reducing the number of shares outstanding. Since buybacks increase the proportionate ownership of a company each share represents, earnings per share can increase even when net income is flat or declines slightly when a company reduces the number of shares outstanding.

Dividends have no impact on earnings, with the exception of distributing cash that could hypothetically be used for growth purposes (in which case, future earnings would be affected). A reduction or suspension of a dividend is a negative event leading to the share price being penalized. Such events are often viewed as evidence of poor business conditions and/or weak underlying fundamentals.

According to economic theory, an investor should be indifferent to dividends or buybacks. Dividends return cash to shareholders. Buybacks increase ownership, giving shareholders a bigger claim to future earnings and larger dividend payments—assuming dividend payout ratios are unchanged and net income is essentially stable. Shareholder yield plays into this concept. Shareholder yield is the sum of the dividend yield (dividends divided by share price) and the buyback yield (the percentage change in the number of shares outstanding). Companies with positive levels of shareholder yield outperform companies with negative levels of shareholder yield. Straehl and Ibbotson used a similar concept to shareholder yield to explain the key drivers of stock returns. Setting aside the mathematical formulas, they show how stock returns have been driven by the total (shareholder) yield, growth in total payout (cash returned to shareholders via dividends and buybacks), the change in share price to total payout and inflation plus a small measure to account for the interaction between these factors.

In the real world, investors consider factors such as the role dividends play in forcing executives to not take excessive risks (because of the penalties associated with cutting or suspending the dividend), the stream of cash from dividends, the noncommittal aspects of buybacks, the positive return attributes of rising dividends, and the ability to delay realizing taxes by opting for non-dividend-paying stocks over dividend-paying stocks. (The tax rates for qualified dividends and long-term capital gains are the same; only the timing of when a taxable event is realized differs.) As such, there are legitimate reasons for favoring dividends or buybacks.

Regardless of personal preference, the bigger message is that the return of capital to shareholders is a positive trait to seek in a stock.