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It’s a problem most companies would be thrilled to have — tens of billions of dollars in free cash flow that can be invested or distributed to shareholders.
Apple AAPL, +0.23% has this happy problem, and one of its solutions has been to give its shareholders some of the cash flow. In fiscal 2019, Apple paid $14.1 billion in dividends and spent $67.1 billion buying back its stock. Many billions more are on the horizon.
Why does Apple prefer buybacks over dividends? Some think it is a big mistake. Fortune magazine published an article a few years ago titled, “Why Dividends Still Beat Buybacks.” The author was seduced by the idea that dividends are real tangible evidence that companies care for their shareholders, writing: “[Dividends are] a check in the mail. A share repurchase goes off into the ether and never benefits Main Street. It’s just money that could’ve come to you that didn’t.”
True, a dividend puts cash in shareholders’ bank accounts, but shareholders can always get cash by selling some of their shares — in essence, a shareholder-determined dividend policy. With today’s free commissions, selling shares is as easy as cashing dividend checks.
Recently, an article in Barron’s argued for a balance between dividends and repurchases, noting: “Apple could take a more-balanced approach and double its dividend while cutting back the annual buyback program by $15 billion to around $52 billion. That would result in a 2% dividend yield, in line with that of the S&P 500.” SPX, -0.29%
Read: These 2 stocks dominated S&P 500 returns in 2019 — and the decade
Balance is good, right? Many employees who are offered a choice between stocks and bonds in their defined-contribution retirement accounts choose 50-50. Many people, when asked whether the reason for some fortunate or unfortunate event was A or B, will cheerfully answer, “Both!”
Maurice G. Kendall, a famous British statistician, once made this wry observation about balance: “If some people asserted that the earth rotated from east to west and others that it rotated from west to east, there would always be a few well-meaning citizens to suggest that perhaps there was something to be said for both sides, and that maybe it did a little of one and a little of the other; or that the truth probably lay between the extremes and perhaps it did not rotate at all.”
Balance is superficially appealing but often there is a single answer — and it is not a balanced splitting of the difference. Workers would have been better off with 100% stocks; A and B are seldom equally responsible; the Earth rotates on its axis from west to east, and share repurchases are generally better than dividends.
John Burr Williams, the father of value investing, was the first person to state the Law of the Conservation of Investment Value: The value of a firm depends on the cash it generates, regardless of how that cash is packaged or labeled. The intrinsic value of a company that distributes some of its free cash flow to its shareholders does not depend on whether that distribution is called a dividend or a share repurchase.
The label does, however, matter to investors. As is often the case, taxes are the deal breaker — making repurchases far preferable to dividends. The federal government taxes qualified dividends at the same rate as long-term capital gains (0%, 15%, or 20%, depending on filing status and taxable income), while ordinary dividends are taxed at the higher income tax rates that apply to wages, interest and other ordinary income.
This tax distinction awards buybacks a clear advantage over dividends. A dividend gives shareholders no alternative but to take the cash and pay the taxes. With a share repurchase, shareholders have a choice. Either they can sell some shares and pay taxes on the capital gains, or they can let their investment ride. Having a choice is better than no choice. In addition, even if they do sell, they don’t pay taxes on the entire sale, only on the capital gain (if any).
Suppose an investor bought Apple for $100 a share in 2016 and the price is now around $300. If the investor receives $900 in qualified dividends, a 15% dividend tax would be $135. If this same investor were to sell 3 shares of Apple for $900, a 15% tax on the $600 capital gain would be $90. The dividend tax is 50% higher than the capital gains tax. The value of Apple stock isn’t affected, but the amount of money left in shareholder bank accounts after the IRS is paid sure is.
Plus, investors probably don’t have to sell Apple, which has tripled in price, in order to get $900. If an investor were to raise $900 by selling another stock that hasn’t gone up nearly so much, the capital gains tax would be far less than $90. Even better, if some stocks in investors’ portfolios have gone down in price, they can sell the losers and deduct the losses against other income.
A great company like Apple paying a 1% dividend is still attractively priced.
No one plans to buy stocks that go down in price afterward, but when it comes to selling stocks to raise cash, there is a compelling argument for tax-harvesting losses by liquidating the investments that didn’t work out. Paying a $135 dividend tax is a lot worse than paying little or no capital gains tax, or realizing tax-deductible losses.
The only persuasive reason for Apple paying dividends instead of repurchasing shares is that it believes that its stock is overpriced. The way to make that wager is for Apple to issue more stock instead of buying back shares. I don’t see Apple doing that. With 10-year Treasury rates TMUBMUSD10Y, +1.25% below 2%, a great company like Apple paying a 1% dividend is still attractively priced. If Apple does not believe that its stock price is out of whack, it should, if anything, increase repurchases instead of dividends.
Gary Smith is the Fletcher Jones Professor of Economics at Pomona College and author of “The AI Delusion” (Oxford University Press, 2018) and co-author of “The 9 Pitfalls of Data Science.” (Oxford University Press, 2019)
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