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Dividends or Buybacks: Which Is Better?

Both have pros and cons, but in today's environment, this is no longer an either-or prospect for investors, who should instead consider total shareholder yield.

Karen Wallace: Hi, I'm Karen Wallace for Morningstar. What's the best way for companies to return profits to shareholders? I want to introduce you to one of my colleagues who spends a lot of time thinking about that question. This is Dan Lefkovitz. He's a strategist in Morningstar's Indexes group.

Dan, thanks so much for being here.

Dan Lefkovitz: Thanks for having me, Karen.

Wallace: So, what are the two main ways that companies share their profits with investors, and what are sort of the pros and cons of each one?

Lefkovitz: Sure. Well, investors love dividends. Especially, in this day and age of ultralow interest rates and demographics being what they are, increasing numbers of investors are looking for income from their investment portfolios. Dividends are straightforward, cash in hand. There's also a total-return story to dividends. Dividends enforce discipline on management. They have to deliver that dividend payment. Share buybacks are more indirect. Now, vis-à-vis dividends, they are more flexible. A company can buy back its own shares when it has cash on hand opportunistically. It's not the kind of straitjacket that the dividend payment is. But the buyback, the share repurchase, does increase fractional ownership for remaining shareholders. So, they both are ways that a company can return cash to shareholders. Share buybacks get criticized for being mistimed, valuation considerations, born of questionable motives, they're often perceived as benefiting management at the expense of shareholders. Tax consequences to dividends are--share buybacks are tax-advantaged relative to dividends. So, pros and cons.

Wallace: So, Dan, which is better from a shareholder perspective?

Lefkovitz: So, we actually think that dividends versus share buybacks is something of a false dichotomy. The fact is that many companies these days do both. And market dynamics have really changed over the past few decades. Share buybacks have become a lot more prominent and have, in fact, eclipsed dividends as a means of returning cash to shareholders. So, the fact is that today's market share buybacks are really big. We know that the dividend yield on the U.S. market is much lower than it used to be. But if you add back in buyback yield and if you look at total shareholder yield, it's more in line with historical averages. And we really think it's useful to think about the total payout of the market. My colleague Philip Straehl in Morningstar Investment Management has done a lot of work on this total payout model, which is a helpful means not just of representing overall market yield but also valuing the market.

Wallace: So, you and your colleagues have spent a lot of time researching this topic and putting together an index. How do you find companies that are standouts in terms of returning cash through this total shareholder yield?

Lefkovitz: So, we built an index several years ago based on this concept of total shareholder yield. It's called the Morningstar US Dividend and Buyback Index. And very simply, it just selects companies that are returning cash to shareholders through dividends, through buybacks, or a combination thereof, and it weights constituents by total payout dollar. So, it considers market capitalization as well as dividend and buyback yield. And we find that when you look for buybacks or dividends or a combination, you broaden the investment opportunity set, you broaden the fishing pool. So, about 1,200 U.S. companies are eligible for the index. The overall dividend yield is above-market. It's attractive from an income perspective. But if you think about total yield, buyback plus dividends, it's even more attractive.

Wallace: We have a list of some undervalued components here and I'll link that in the video notes. Thank you so much for being here. This is really interesting research, Dan.

Lefkovitz: Thanks, Karen.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.