Q: The financial media certainly gets all excited about increased dividend payments and share buyback announcements. Are they really all they’re cracked up to be?
I’d say both the media and investors get overly excited when companies announce plans to buy back their own shares. And, for that matter, dividend hikes get too much play as well.
The best way to understand this issue is to first go back to basics.
A company, public or private, only has four things it can do with its profits. It’s really pretty simple.
First, a company can reinvest its profits to grow organically. Second, it can use its cash to make an acquisition. Next, it can pay down debt to both save on interest cost and improve its overall financial flexibility. And, finally, it can return excess cash to shareholders through either dividend payments or by doing a share buyback. This set of choices is known as, capital allocation.
Regardless of the choice made, the only thing that should matter to investors is whether or not their capital is being allocated wisely. A key job of the elected board of directors is to monitor the capital allocation suggestions made by their hired executives. Unfortunately, in an effort to reside in the cushy confines of that corporate club, they often fail at their primary responsibility.
This brings me to the truth about dividends and share buybacks.
Business leaders know that dividends aren’t easy to cut once they’ve begun. Paying an ongoing dividend implies a certain level of confidence in its future profitability. Since investor confidence often produces a higher stock price, it is one reason to like dividends. But, it is not a legitimate reason to always choose dividends over the other options available to use the cash.
For example, if a business happens to have a great opportunity to grow, it would certainly be a shame if shareholders were so smitten with their dividend as to actually take a pass on those prospects.