Are Dividends or Stock Buybacks Better for Investors?

By Markets Fool.com

There are two main ways companies return capital to their shareholders: dividends and stock buybacks. Some companies pay very generous dividends, others prefer to buy back their own shares, and many companies utilize a combination of the two.

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So, which is best? We asked three of our analysts which method of profit distribution they prefer, and here is what they had to say.

Matt Frankel: Of the two, dividends are obviously the better choice for investors who want current income. However, for most people, I would make the case that share buybacks are actually the more favorable option.

For one thing, a stock repurchase has a more favorable tax treatment. When a company pays you a dividend, it will be taxed at a 15% rate for most tax brackets (assuming the dividend is "qualified"). With a share buyback, it simply raises your interest ownership slightly. Share repurchases are tax-free until you decide to sell.

Also, a company has more flexibility when it comes to a share buyback. Dividends are expected to be consistent from quarter to quarter, but if management approves a certain amount of share buybacks, say $1 billion, the company is free to use the money to buy shares at a time of its choosing, and in an amount of its choosing.

Most importantly, completing a share repurchase is a company's way of saying that it believes its own stock is cheap, and that the company's profits would be better spent buying back shares than given to shareholders as dividends. It is a much better sign of confidence than a dividend, and a very large buyback program can be a very bullish signal.

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Patrick Morris: In July, Harvard Business Review published an article called The Answer to Every Business Question Is "It Depends," and in my opinion, that is absolutely true when considering whether buybacks or dividends are better for investors.

For those on the hunt for income, dividends are clearly preferred. And while dividends can be created through a slow shedding of a stake in a firm, such a solution is much less certain than a commitment from a company to return a designated amount each quarter in the form of a dividend each quarter.

But if the company is managed by those with sound financial discipline and a capable capital allocation strategy -- like Berkshire Hathaway -- then each dollar paid out in dividends is one less dollar that can be used to maximize future earnings to create value for shareholders.

However, in the same light, there have been countless examples of companies that bought back shares at exactly the wrong time, which clearly destroyed value. So, share buybacks aren't always a great thing either.

All of this is to say, when it comes to deciding what is best for investors, it has less to do with what policy is -- whether buybacks or dividends -- and more to do with the management team who makes the decision.

Dan Caplinger: On its face, it shouldn't make any difference whether a company returns capital to shareholders via dividends or stock buybacks. But dividend stocks have a dramatic performance advantage over their non-dividend-paying counterparts over the long run, and much of the reason has to do with the commitment that dividend payers implicitly make to their investors.

As Matt notes, buybacks give companies complete flexibility to decide exactly when they want to spend their available capital. They can add to buyback authorizations at any time, and even once a repurchase is authorized, they don't have to actually follow through on a buyback if conditions become less favorable. Yet as Patrick points out, all too often, companies end up making ill-timed buyback decisions that lead to them buying their stock during the best of times.

By contrast, once a company establishes a dividend, investors expect the company to keep paying it through thick and thin. That imposes a discipline on the company to keep performing well even in hard times, and it gives shareholders the ultimate decision of whether to reinvest their dividends back into the same stock or to use the income for their own purposes. Dividend investors benefit from that discipline, and it's a big part of why so many of the top-performing stocks of the past several decades have paid substantial dividends to their shareholders.

The article Are Dividends or Stock Buybacks Better for Investors? originally appeared on Fool.com.

Dan Caplinger owns shares of Berkshire Hathaway. Matthew Frankel has no position in any stocks mentioned. Patrick Morris owns shares of Berkshire Hathaway. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.