R  I  V  E  R   P  O  I  N  T 

R  E  P  O  R  T

April 2006

The Value of Dividends and Stock Buybacks

Many equity investors ignore dividends and think of a stock’s value simply in terms of its price appreciation. But owning a share of stock is nothing more than owning a share of a business thus entitling an investor to a share of the company’s profits. These profits can be reinvested in the business itself or they can be spent by the company to buy back its own shares, consequently boosting earnings per share resulting from fewer shares outstanding. Another option that a company has is to pay out profits in the form of dividends, in which case the investor ends up with the cash.

There are two schools of thought regarding which is the better use of cash - buybacks or dividends. In an ideal world where management is only concerned with shareholders’ best interests, buybacks would probably be the wiser choice. But the reality is that a lot of buybacks are announced and never completed or the shares are repurchased strictly to offset option grants. And while dividends usually come out of operating cash flow, debt is used for buybacks in some instances. With a cash dividend, however, the money goes right into investors’ pockets. A dividend policy imposes discipline on management in that they have an obligation to pay out cash to shareholders.

Since a stock’s performance in a portfolio is based on total return, i.e., the annual price appreciation (or loss) plus dividends, stocks that pay dividends can boost long-term returns significantly. Consider the following example. If an investor had purchased shares of Bank of America fifteen years ago, the return by simple price appreciation would be approximately 11.7% annualized, or about 1% more than the performance of the S&P 500 index over the same period. But with dividend reinvestment included in the calculation of performance, the total return would be 15.6% or about 4% more per year annualized versus the S&P 500.

One may conclude that the key is to simply buy the highest yielding stocks for superior returns. However, focusing on dividend yield is limited in that it equates only to the current yield and gives no indication of future prospects with regard to earnings and dividends. Consider a scenario in which an investor debated investing in either General Motors or Procter and Gamble five years ago. GM looked attractive with a yield of almost 4% while P&G was yielding about 2.2%. Five years later the total return on GM would be negative including dividends while the total return from P&G would be about 15% per year annualized. During this period P&G was able to grow its dividend over 10% compounded annually per year while GM’s dividend was reduced. This example demonstrates the importance of looking beyond the current yield to the company’s ability to grow its dividends.

Companies can also return wealth to shareholders through share repurchases, which have the effect of reducing shares outstanding thus increasing earnings per share. Consider TJX Companies, an off-price retailer of apparel and home fashions in the U.S. and worldwide. TJX increased net profits by about 5% annualized over the last five years but earnings per share increased about 14% per year annualized as TJX repurchased almost 100 million shares over this period. During the five year period ended December 31, 2005, total return was almost 12% annually. By comparison the S&P 500 was basically flat during this five-year period with dividends included. Since TJX Companies also increased its cash dividends by 20% compounded annually over the last five years, this provides a great example of how a company can return wealth to shareholders under both scenarios.

The stock market in 2006 offers what we at RiverPoint believe are great opportunities because of the current business fundamentals. Profit margins are at a thirty-year high and free cash flow is also at a record level. Corporations have reported their fourth straight year of double-digit earnings growth. After corporations make the needed investments back into their businesses, there should be plenty to return to shareholders through dividends and stock repurchases.

Trivia

First published on May 26, 1896, the Dow Jones Industrial Average (DJIA) represented the average of twelve stocks from various important American industries. Of those original twelve, name the only company that remains part of the average today.

The other eleven were:

• American Cotton Oil Company, a predecessor of Bestfoods, now part of Unilever
• American Sugar Company, now Amstar Holdings
• American Tobacco Company, broken up in 1911
• Chicago Gas Company, bought by Peoples Gas Light & Coke Co. in 1897 (now Peoples Energy Corporation)
• Distilling & Cattle Feeding Company, now Millennium Chemicals
• Laclede Gas Light Company, still in operation as The Laclede Group
• National Lead Company, now NL Industries
• North American Company, broken up in the 1950s
• Tennessee Coal, Iron and Railroad Company, bought by U.S. Steel in 1907
• U.S. Leather Company, dissolved 1952
• United States Rubber Company, changed its name to Uniroyal in 1967, bought by Michelin in 1990

Answer: General Electric

Market Summary	4/28/06	YTD Price Change
Dow Jones Industrial Average	11,367	+6.1%
Nasdaq Composite	2,322	+5.3%
Standard & Poor’s 500 Index	1,311	+5.0%

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