Excess cash flow also provides the opportunity to enhance shareholder returns through dividends and share buybacks.
Dividends are precious because they help overcome periods of weaker earnings growth. Receiving a regular payment from the invested company creates a link – affectio societatis - between the shareholder and his company. Rather than spending them, it is better to put the dividends back to work and their reinvestment is a primary condition for successful compounding. Furthermore, history shows that dividends are responsible for about half of the total long-term return of 6% to 7% per year generated by the market. The importance of dividends increases as earnings growth slows.
While the value of dividends is not debatable, we can be more critical of share buybacks, because their rationality is not always completely clear. In theory, it makes sense for a company generating excess cash to buy its own stock when it is undervalued. In practice, however, companies even buy back grossly overvalued shares, citing the tax advantage of buybacks over dividends, for example. Unfortunately, the real motivation behind buying back own stock is often twofold: 1) pushing the stock price higher and/or 2) reducing the number of shares which automatically increases earnings per share. It may not be pure coincidence that these two elements, share price and earnings per share, are often among the key indicators of executives’ performance.
To avoid finding ourselves in the company of manipulative managers, we scrutinize companies that resort to share buybacks a little too often.