DR 060: The Basics of Dividends, Stock Splits, and Buybacks

Optimized-TEXT HEREWhat are dividends, buybacks, and stock splits? Are they good or bad for investors.

These things have a big impact on investors, but many investors don’t really understand them. So we’re going to talk about what these three things are in the context of a popular, well-known company – Apple.

Recently, Apple announced its second quarter results, which were quite good. Its revenue and earnings are up, and the sales of iPhones increased – which was surprising in this market. This is significant for Apple because iPhones are their biggest product with, probably, the biggest profit margins. Some people believe the margins on iPhones are higher than 50%, which is just phenomenal. So to see an increase in iPhone sales – particularly when there were no new produce releases in the past quarter – really gave the market some confidence in Apple with regard to the future.

While I don’t get too excited about a single quarter’s result, this was a nice thing to see, especially as an investor in the company. I’ve owned Apple stock for a while now, and I follow it very closely. Apple also announced that it will increase dividends and the stock buyback program. It is also going to split its stocks to seven for one.

Dividends, buybacks, and stock splits matter for any investor in a company – whether you own individual shares of a stock or whether you own shares of that company through a mutual fund or ETF. When a company – especially one as significant as Apple – increases its dividends and buyback programs and splits its stocks, it will affect your investment in the company.

Now, the effect on your investments will vary. If you invest in Apple, for instance, through a mutual fund or ETF that owns shares in hundreds of different companies, the impact may be relatively small. But it will still affect you.

So what does all this mean? Let’s dig into the details:

Stock Splits

A stock split is when a company divides its existing shares into multiple shares, and then reduces the price per share by that same multiple.

For instance, one common stock split is two for one. Let’s imagine that you own one share of a company, and that share is trading at $100. If the company does a two for one stock split, they take your one share and replace it with two shares. But whereas the one share was trading at $100, the two shares are only going to trade for $50 each. So the total value of your ownership and the percentage of the company you own haven’t changed at all.

As I mentioned above, Apple announced a seven for one stock split. So for each single share I now own, Apple is going to give me seven new shares. But the price of those shares will be 1/7 what it was before, so the total value of my stock in Apple and the percentage of the company I own won’t change at all.

So why do companies even bother with stock splits? Well, some of them don’t. Berkshire Hathaway is a well-known company that refuses to split stocks – at least its A shares (it did split its B shares in 2010). Because Berkshire Hathaway hasn’t split the A shares, their price has gone up a lot over the last few decades. A single share now trades at about $190,000.

When companies do split their stocks, the primary reason is to make their shares more affordable to retail investors. Before the stock split, Apple shares were trading at about $525 to $530 per share. After the recent announcement, the trading value will probably bump to $560 or more. By declaring a seven for one split, Apple has reduced the price of a single share by seven fold. The theory is that this makes Apple stock more affordable for retail investors.

Personally, I don’t like this reason for splitting stock. The fact is thatthe majority of people can invest in Apple when they want to. Maybe you can’t buy a full share at $560 each, but you could buy a fractal share through some brokers. Stock splits are supposed to increase liquidity, and there may be some truth to that. But I don’t particularly like this reason for splitting stocks.

Other times, the reason for a stock split is more transactional. For instance, in 2010 Berkshire Hathaway split its B shares. At that time, the B shares were trading for around $3,000. The company took them down to about $100 per share. This was part of their acquisition of Burlington Northern. It involved some of the B shares going to Burlington Northern investors. So Berkshire Hathaway needed to bring down the price of each share and the percentage of ownership it represented, and it did that with a stock split.

One other reason for stock splits is that sometimes management will split stocks to increase the share price to benefit their own options. When a company splits its stocks, it tends to increase what the market will pay for the share of the company.

How does that work if the stock split doesn’t actually change how much value or what percentage you own? There’s not really a rational reason. The market seems to like stock splits. Management knows that, and sometimes they want to boost the price per share so they can make their own options more valuable. This seems cynical, but it happens. I don’t mean to suggest that this was Apple management’s motivation, but sometimes this is a reason companies undertake a stock split.

As I said, I’m not generally a fan of stock splits. They don’t change the intrinsic value of the company. They don’t change my ownership in the company.

It reminds me of a Yogi Berra quote. The famed New York Yankees’ catcher was famous for his somewhat nonsensical quotes. One that seems relevant here is, “You better slice the pizza into four pieces because I’m not hungry enough to eat six.” It doesn’t really matter how many pieces you cut the pie into because it’s still going to be the same amount of pizza. The same is true with stock splits.

Dividends

Apple also announced that it was increasing its quarterly dividends by eight percent. Previously, their quarterly dividend was $3.05 per share, and now it’ll be $3.29 per share. Do these increased dividends help or hurt investors? It just depends.

Dividends can be paid in cash, or they can be paid in the form of shares. When people talk about dividends, they talk about cash dividends most of the time. This is when the company returns some of its cash to the shareholders. The company just writes the investors a check for the money.

Profitable companies generally use their cash in one of three ways.

The first thing they can do is to re-invest the profits into capital investments to maintain the existing business. Maybe they need to upgrade software or replace their computer systems, or maybe they need to upgrade or replace machinery at a factory. These sorts of investments won’t actually expand the business. They simply maintain it where it already is.

The second option is to use the cash flow to expand or grow the business. Maybe they’ll build a new plant or open up new stores. They may invest in research and development.

The third option is one a company might take when it gets through the first two. If the company takes care of its capital needs and investing in its own growth but still has leftover cash, it might return some of that to investors in the form of dividends. Usually, more mature companies begin to return cash to shareholders in the form of dividends.

Not long ago, Apply didn’t pay a dividend. At the time, they were growing and introducing new products too quickly to do this. They were opening retail stores, too, which required a lot of capital. But they finally got to a point were they had so much cash they couldn’t invest it into the business, so they started to return some of that to investors in the form of dividends.

Looking at Dividends as an Investor

There are three things to consider about a company’s dividend policy:

Dividend Yield: When you’re looking at your own investments and dividends, the first thing to look at is a company’s dividend yield. The yield is calculated by the dividends per share by the price per share. In the case of Apple, the yield would be $3.29 times four (to get annual dividends) divided by its current price per share. At its current price of about $590, its new yield will be about 2.2%.

Dividend yield can be helpful for a couple of reasons. First, it tells an investor the amount of income the investment will generate. Second, it can help an investor compare investments in different companies.

Dividend Payout Ratio: This ratio is simply the percentage of earnings paid to shareholders. It is calculated by dividing the annual dividends per share by the annual earnings per share. As a company uses more and more of its earnings to pay dividends, investors should be cautious about the company’s ability to continue making these dividend payments. If earnings were to fall, the company might lose the ability to maintain its current dividend policy.

You can find all of this information easily on MorningStar, Google Finance, or CNN Money. Both the dividend ratio and payout ratio are available on these sites.

Right now, Apple’s dividend yield is 2.32%. They’re going to increase their dividend, but the price per share is also going to go up. So it’s likely that the dividend yield will stay the same – or it could even go down a bit, even while the actual dividends they’re paying rise by 8%.

Dividend Historys: Finally, it’s important to examine a company’s history of paying dividends. Has the company continuously paid increasing dividends over a number of years? Has the company ever had to stop paying dividends because of low earnings? While past performance doesn’t guarantee future performance, it’s some of the best data we have.

Stock Buybacks

Buybacks are pretty simple. A company buys back its own shares from the market. Why would a company do this? It’s because they have extra cash, and they don’t necessarily want to return that to investors in the form of dividends. The important question is whether buybacks are good for shareholders. They answer is it depends.

Buybacks are a significant advantage over dividends–they are not a taxable event for shareholders. If you have investments in taxable accounts, buybacks will not trigger capital gains or other taxes. Nevertheless, two things must occur for a buyback program to benefit investors:

First, the company must buy its shares at a reasonable price. Just like any investor, if a company pays too much for its own shares, the buyback hurts investors. Second, once purchased, the company must not do stupid things with the shares. The best option is simply to retire them. Unfortunately, many companies buyback shares only to pass them out to management in the form of options.

So those are things to think about when a company implements a buyback program: Is the company buying undervalued – or at least fairly valued – shares? Or are they paying too much for their stock, which will hurt investors in the long term? Also, when they buy the stock back, what will they do with the shares?

Published or Updated: May 2, 2014
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

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