Saturday, September 08, 2007

Buybacks To Replace Dividend Payments?

In a recent research report by Douglas J. Skinner titled, "The Evolving Relation between Earnings, Dividends, and Stock Repurchases," Skinner concludes there may come a time when dividends completely disappear. From a contrarian perspective, I hope this research report is one indication dividends will become more important in an investor's mind. His report notes dividends are based on earnings; therefore, using a dividend growth approach as a measure to evaluate a company's future growth prospects is beneficial. On the other hand, the report notes buybacks are gaining in popularity and evaluating buyback activity for a firm may be another approach of choice going forward.

I do believe buyback activity can be a useful metric to use in evaluating the prospective growth of a company's future earnings. The risk is buybacks are not a long term commitment by a company to return capital to shareholders. Dividends are more of a longer term commitment as companies know the market penalizes its stock price if dividends are reduced or eliminated.

Some facts Skinner details in his research report:
  • Skinner shows that the increased volatility of earnings helps explain changes in payout policy over the last 30 years.
  • First, Skinner shows that since 1980 there have been three main groups of payers: 1) established firms that have always paid dividends and now also make repurchases on a regular basis; 2) firms that make regular repurchases but do not pay dividends; and 3) firms that make occasional repurchases.
  • Skinner finds that firms in the first group have been paying dividends for decades and continue to do so largely because of their dividend history. Over time, managers of these firms increasingly use repurchases to pay out earnings increases, with dividend policy becoming more conservative. This suggests the reluctance to reduce or omit dividends has become stronger in recent years (emphasis added). Skinner also finds that these firms dominate the set of publicly held firms, accounting for more than half of all total earnings and payouts.
  • Dividend policies are incredibly sticky once firms have established a dividend amount, they feel as if they have to maintain that level of dividend going forward.
One of the important points from the study is:
  • ...prior research has shown that managers set dividends based on current and past earnings.
The above point is a strong reason why an investor can use a firm's dividend policy and practices to assist in projecting future earnings prospects.

From a historical perspective, aggregate buyback amounts now exceed aggregate dividend payments. I noted this in an earlier post, Stock Buybacks Continue At A High Level.

From a cautionary standpoint, Skinner finds, "those firms that both pay dividends and make repurchases have a conservative dividend policy and use repurchases to supplement dividends in years with strong earnings." The issue here is the buybacks are based on past earnings and cash flow results and not on a company's expectations of future earnings prospects.

When evaluating dividend growth aspects of a firm, the growth rate of a dividend is an indication of a company's future earnings growth prospects. This was detailed in a study by Robert Arnott and Clifford Asness titled, Surprise! Higher Dividends = Higher Earnings Growth (pdf).

The Dividend Puzzle
Capital Ideas
By: Douglas J. Skinner
August 2007

The Evolving Relation between Earnings, Dividends, and Stock Repurchases
Social Science Research Network
By: Douglas J. Skinner
May 2006

Buyback vs. Payout($)
By: Shirley A. Lazo
September 10, 2007

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