The two main ways companies reward shareholders is via dividends or buybacks. There has long been a debate about which of the two is better. Both have there advantages and disadvantages and that is why many blue chip companies use a combination of the two.
Buybacks Vs Dividends
- Dividends – When a company pays a dividend, it is essentially giving a share of its profits to its owners/shareholders. Dividends are usually paid at regular intervals and the best blue chip companies grow their dividend over time.
- Buybacks – A share buyback refers to the purchase by a company of its shares from the marketplace. As a result of a buyback exercise, the company’s shares outstanding decreases and thus each existing investor has a greater ownership stake in the company. Buybacks usually increases per-share measures of profitability like earnings-per-share (EPS) and cash-flow-per-share, and also improves performance measures like return on equity.
The empirical evidence points to dividends being a better reward for shareholders as the business sends cold hard cash to the investor so that they could use it in any way they like. Companies also have the knack of getting it wrong when conducting buybacks. They usually undertake a buy back programme when the company is flush with cash and the stock is trading at all time highs thus leading them to overpay in more instances. Just look at how buybacks stopped in 2008-2009 when they should have been increased. Furthermore, dividends don’t artificially inflate the stock price like buy backs do thus creating no chance for management to manipulate the stock price in order to exercise their share options.
But on the other hand, as an investor is foreign shares, a different way of thinking needs to precede and in this case, buybacks should be preferred over dividends.
When Buybacks are better than Dividends
As a dividend growth investor, I prefer companies to pay me a dividend as opposed to conducting stock buy backs. I prefer the feeling of cold hard cash hitting my account as opposed to seeing the shares I own rise in price due to a buyback programme. But there is one exception.
When I buy shares in foreign companies, ones listed on the NYSE or Deutsche Boerse for instance, I would prefer these companies to conduct buybacks over paying dividends. The reason is simple – withholding tax.
A dividend withholding tax is a tax that is automatically taken off by the government of the country where the company you are invested in is based. This essentially means that whenever a foreign listed company pays me a dividends, I don’t get the full amount declared. Instead, I need to give up a certain amount as withholding tax. The withholding tax differs from country to country and you can see the different rates here.
To see how dividend withholding tax works in practice, let’s look at my recent purchase of Coca Cola (KO) stock.
Coca Cola has a current annual dividend of $1.45. So if you a US based investor, you will get the full $1.45 a year paid into your account. But as a British investor, I only receive $1.19 for that same share of Coca Cola stock. This is the $1.45 less the 15% dividend tax withheld by the US government.
Whilst 15% doesn’t sound like much, it does add up when you have large holdings. If I had 1000 shares in Coca Cola, I would only receive £1,190 as opposed to $1450 received by a US investor. The exact same stock, but as a foreign investor, I get £260 less. And we all know the power of compounding and how the £260 a year can add up over time!
On the other hand, when a company conducts buybacks, I get the full reward. I get the same ownership increase every other investor gets. I am not discriminated upon for being a foreign investor. This is why I would prefer my foreign holdings to conduct buybacks as opposed to handing out dividends. This is the rare occasion that I would prefer a capital gain over income.