Dividends vrs Buybacks

There are basically two ways a company can return cash to shareholders: dividends which are usually paid quarterly at a fixed rate set by the board of directors and stock buybacks which are also declared by the board but not on a regular schedule. I have mixed feelings about each method of rewarding investors and discuss my concerns in this post. Dividends are the most stable and reliable form of rewarding shareholders. An investor can reasonably estimate how much a stock will return via dividends for the entire year which helps when estimating the tax owed on the income. Dividends are also classified into two catagories: qualified and unqualified. Qualified dividends are the most common and are what domestic companies pay shareholders. They are taxed like capital gains which is capped at about 12% for most investors. I usually opt to reinvest these dividends into additional shares of stock which helps to increase my return over time. Even though I reinvest the dividend, the IRS still wants their cut at the end of the year which reduces my return. Dividends have been an important source of income recently because interest rates paid by banks and credit unions have been minimal for over a decade. Many quality stocks have yielded over 4% for many years and they often increase the dividend each year. To cipher your actual yield for a given year, simply divide your payments by the amount you paid for the stock. The result may suprise you. My only warning about reinvesting dividends is to retain your statements because they will be necessary when you sell a holding. A basis must be established to figure your capital gain or loss. Without this information, the IRS consideres ALL the proceeds as capital gain. Stock buybacks on the other hand are not a taxable event. When a company buys back their shares what happens is the outstanding number of shares are reduced. With a smaller number of shares outstanding, the same amount of earnings looks better when expressed as earnings per share. Higher earnings per share MAY result in a higher share price because many investors seek increasing EPS. The board of directors will authorize a share buyback when they feel that their stock is undervalued or when profits rise to a level that reduces their need for capital. While buybacks are the most tax efficient way for a company to return capital to shareholders and I feel that I am already overtaxed on my investments, buybacks have some inherent flaws. I like to make my own investment decisions such as what to buy and when to sell, that is why I invest in stocks over mutual funds. Stock buybacks bypass my choices of investing because the board of directors have decided to invest my money in their company instead of returning capital to me and allowing me to decide where I invest. Also history has shown that BOD's are not very good at timing the market, thereby wasting money on an overvalued stock. A dividend paid to investors gives me the choice of whether to reinvest or not albeit with the pain of a tax liability. Buybacks also come with the potential of financial engineering by directors. A company can increase EPS without increasing actual earnings through buybacks. If a business was really robust, wouldn't that buyback money be better spent on expanding operations than reducing shares outstanding? Finally, attempting to influence the stock price through buybacks dosen't always work because market trends are the defining force when it comes to stock prices. The current downtrend in stocks is a prime example. Do I prefer dividends over buybacks? There is no easy answer. While I like the steady income from dividends, I'm not too keen on the tax bite they come with. Buybacks are much more tax friendly but the possible abuses are clear. In the end, I want both from my investments. A reasonable dividend which is raised each year plus stock buybacks during times of plenty, sounds like a good balance between income and stock appreciation.