The Importance Of Dividends And Buybacks* Ratios For Gauging Equity Values

June 27, 2011

 
The Importance Of Dividends And Buybacks1 Ratios For Gauging Equity ValuesAnalysts who are the most bearish on the U.S. equity markets point to expensive valuation ratios on the S&P 500, notably the dividend yield,2 which is considerably below its long-term average. John P. Hussman, Ph.D., president and principal shareholder of Hussman Econometrics Advisors, the investment advisory firm that manages the Hussman Funds, is well known for being in this bearish camp. Summarizing his case for the U.S. equity market, Hussman wrote last year:

"Over the past 13 years, the total return for the S&P 500 [Index] has averaged just 3.23%. Why have stocks performed so poorly? One word. Valuation… It is not a theory, but simple algebra, that the total return on the S&P 500 [Index] over any period of time can be accurately written in terms of its original [dividend] yield, its terminal [dividend] yield, and the growth rate of dividends."3

Hussman then points out that the current dividend yield on the S&P 500 Index is just around 2 percent, when the average across time was considerably higher. Similarly, Robert Shiller's research on the equity markets shows that from 1871-1982, the average dividend yield for the S&P 500 Index was above 5 percent.4 Given that current dividend yields on the S&P 500 Index are well below that historical average, at face value, the bearish arguments may unwittingly scare investors out of the equity markets.

While the idea of the market being driven by yield is compelling in its simplicity, I believe Hussman's analysis fails to account for a critical market dynamic: share buybacks. Firms generally have three strategic ways they can utilize excess cash: Firms can either pay dividends; engage in share buybacks; or use the cash for other investments, such as acquiring other companies or expanding operations. An increasing number of companies, perhaps driven by a belief that modern equity investors have more appetite for capital appreciation than income, have opted to supplement their traditional dividend payments with share buybacks. In a share buyback, a company invests in itself by using cash to repurchase its shares from investors; this share buyback results in the company reducing its float, thus causing share prices to rise, all else being equal. When one accounts for the combined cash that is being returned to shareholders both from share buybacks and dividends, the market's valuation levels look more enticing.

Dividends Or Buybacks: What's The Difference?

Firms have engaged in increased share buyback activity over recent years. While theoretically buybacks function in very similar ways as dividends as a method of returning cash to shareholders, there are some key differences between dividends and buybacks. The key differences include:

1) Distribution of Cash

  • Dividends: All shareholders of a firm receive dividends when they are distributed.
  • Buybacks: A select group of investors sells shares back to the company either in the open market or during a period in which investors receive the option to sell all or a portion of their shares back to the company within a certain time frame known as a "tender offer" period. Only those who elect to sell their shares back to the company during the buyback program receive cash, and there is risk that if investors defer selling to the future that stock prices will move lower.


2) Timing of Benefit

  • Dividends: The benefit, or the cash received, from dividends occurs at the time the dividends are paid, and therefore reflect a historical measure.
  • Buybacks: The benefit from share buybacks—a reduction in shares outstanding—is a benefit that applies to future distributions. Even though only a portion of shareholders sell their shares back to the company, the reduction in shares benefits all the remaining shareholders; the total future cash distributions by the firm are divided in the future among a smaller shareholder base. The concomitant rise in share price associated with the reduction in float benefits all investors on paper at the time of the buyback, and at the time of some future sale in cash terms.


3) Transparency

  • Dividends: Once firms state their intention to pay a regular dividend, the vast majority in the United States follow through with that commitment unless there is an extraordinary downturn in business prospects.
  • Buybacks: Firms announce plans to buy back stock that often are not carried through to execution.

In pure finance theory, when it comes to weighing the pros and cons of the features of dividends and buybacks outlined above, share repurchases are often a preferred method for returning cash to shareholders. Investors like share buybacks because they support higher stock prices5 and one can choose the timing of share sales (and tax consequences) at a point in the future; dividends, by contrast, are taxed at time of distributions and the investor has no choice for when she receives the dividends.

In practice, however, firms do not consistently implement a share buyback program at the regular quarterly frequencies that firms pay cash dividends. On balance, whether firms use their cash for share buybacks or dividends, at worst, finance theory leads me to believe investors should be indifferent, and at best prefer that firms undertake share buybacks. The key point to realize is that firms are distributing cash to shareholders both by dividends and share buybacks, and one must account for both ways when gauging the historical relative valuation levels of the market.

Historical S&P 500 Buyback Data

Howard Silverblatt of Standard & Poor's publishes historical dividends and buyback data on the S&P 500 Index only as far back as the last decade. As of Dec. 31, 1999, buybacks had surpassed dividends, but each was only slightly more than 1 percent, so the combined dividend and buyback ratio was just above 2 percent (see Figure 1). The collapse of the financial sector caused dividends to decline 20 percent from 2008 to 2010. Still, dividends increased cumulatively 45 percent over the last decade. Buybacks were more volatile than dividends over the decade but also increased significantly, and as of Dec. 31, 2010, the S&P 500 Index level was still well below its December 31, 1999, level of 1469.

Figure1
Source: Standard & Poor's. Data as of Dec. 31, 2010.

The buyback ratio is a market valuation measure used to gauge what percentage of index market value is being reduced by share buyback activity of firms. The dividend and buyback ratio aggregates the dividends and buybacks together to represent a market valuation metric based on two common ways (dividends and buybacks) that firms distribute cash to shareholders.

Because the prices were down, and dividends and buybacks were each up significantly, the dividend and buyback ratios on the S&P 500 Index approximately doubled from Dec. 31, 1999 to Dec. 31, 2010. Note as of Dec. 31, 2008, the combined dividend and buyback ratio was over 7 percent, and at the bottom of the market in March 2009—when the S&P 500 Index touched 666—the dividend and buyback ratio was over 10 percent of the index price.

Why is analysis of dividend and buyback ratios rare in the industry?

If the dividend and buyback data is so important for monitoring the valuation levels of the market, one might ask why it is not a more common practice among index data providers. The fact is that data on index-level share buyback activity is currently not widely available (aside from the above insightful analysis provided by Standard & Poor's on the S&P 500 Index). To combat this dearth of data availability, WisdomTree began collecting data as of the trailing 12 months for the 2010 year-end on share buyback activity across its global index family, starting to help give context for how dividend and buyback ratios range in various parts of the world as well as in U.S. markets.

Aggregate US Share Buybacks Are Now Higher Than Aggregate US Dividends

To further explore the role of buybacks in the equity markets, we examined our in-house index series, and found that in the United States, share buybacks have surpassed dividends in terms of aggregate distributions to shareholders (see Figure 2). WisdomTree has two U.S. equity families. One family, the WisdomTree Earnings Indexes, is generally based on the profitable companies in the United States; the other, the WisdomTree Dividend Indexes, is generally based on the dividend payers in the United States.

Analysis of the buyback levels on these indexes reveal some key insights about what types of companies are issuing buybacks. This analysis is solely meant to be used as a commentary on how firms are distributing their cash to shareholders and the resulting implications for the overall valuation levels of WisdomTree's indexes and the markets covered by them.

  • Dividend Stream: The total aggregate dollar value of dividends paid for the WisdomTree Dividend Index as of Dec. 31, 2010 was $247 billion.
  • Buybacks: The total aggregate share buybacks over the prior 12 months for the WisdomTree Earnings Index as of Dec. 31, 2010 was $306 billion, about 24 percent higher than its trailing 12-month dividend stream.
  • The buybacks for the WisdomTree Dividend Index were $240 billion, about $66 billion below those of the WisdomTree Earnings Index. The higher level of buybacks for the Earnings Index is largely a result of technology companies preferring buybacks over dividends and the fact that technology stocks comprise the largest weight in the WisdomTree Earnings Index but are less represented in the WisdomTree Dividend Index. Technology sector companies comprised $80 billion of the $300 billion in buybacks from the Earnings Index total, or approximately 26 percent.

Because share buybacks function largely in the same theoretical way of returning firm cash to shareholders as paying dividends, an evaluation of the market's valuation ratios more appropriately includes analysis of the dividend yield and share buyback ratios. The buyback ratio for the index is calculated in a similar fashion as a dividend yield is calculated.6

Figure 2

Sources: WisdomTree, Bloomberg, S&P

The buyback ratio is a market valuation measure used to gauge what percentage of index market value is being reduced by share buyback activity of firms. The dividend and buyback ratio aggregates the dividends and buybacks together to represent a market valuation metric based on two common ways (dividends and buybacks) that firms distribute cash to shareholders.  

Key data highlights as of Dec. 31, 2010:

  • The buyback ratio of the WisdomTree Earnings Index at 2.47 percent is about 30 percent greater than its dividend yield of 1.9 percent, and when dividends and buybacks are added together, the combined dividend and buyback ratio is 4.4 percent.
  • By contrast, the dividend yield of the WisdomTree Dividend Index at 3.2 percent is more than 50 percent greater than its buyback ratio of 2.1 percent. When dividends and buybacks are added together, the combined dividend and buyback ratio is 5.3 percent.
  • By these measures, the combined dividend and buyback ratio of the WisdomTree Dividend Index, at above 5 percent, implies that valuation levels for WisdomTree's indexes are reasonably similar to the historical norms of the S&P 500 Index when buybacks were much less common practice.
  • Small-caps had lower buyback ratios than large-caps. Both within the dividend-weighted and earnings-weighted index families, small-caps had approximately 1 percentage point of lower buyback ratios compared with the large-caps.

In addition to the data focused on the United States, we also examined dividend and buyback ratios across global indexes (see Figure 3). Some takeaways from global analysis (all data below as of the trailing 12-month period as of Dec. 31, 2010):

  • United States-based firms engaged in significantly more share buyback activity than foreign firms. The total global aggregate buybacks of the WisdomTree Global Dividend Index were $282 billion, of which the U.S. firms represented 85 percent of all global share buybacks.
  • The WisdomTree Global Dividend Index had a buyback ratio of just 0.70 percent compared with 2 percent for the U.S. WisdomTree Dividend Index and 2.5 percent for the U.S. WisdomTree Earnings Index.
  • The emerging markets engaged in more share buybacks than foreign developed markets and display higher buyback ratios than foreign developed markets. The aggregate share buybacks of the WisdomTree Emerging Markets Dividend Index was $26 billion, compared with just $14 billion from the WisdomTree DEFA Index, which is a dividend-weighted index of the developed world dividend payers.
  • The combined dividend and buyback ratios across WisdomTree's four regional equity income indexes are remarkably similar, all within a range of 5.6 to 5.9 percent. The U.S. Equity Income Index had the lowest dividend yield of the group at 4.35 percent, but its buyback ratio was the highest at 1.41 percent, giving it a combined dividend and buyback ratio in the middle of the range of the various regions.
  • Within the small-cap segment of the market, the U.S.-based dividend index had the highest combined dividend and buyback ratio, at 5.2 percent. The second-highest dividend and buyback ratio was for the Emerging Markets SmallCap Dividend Index, which was higher than those of the Developed International and Europe SmallCap Dividend Indexes.

Conclusion

At the beginning of this research piece, we cited a formula often used in setting return expectations for the equity markets that decompose the total return into three components:

  1. The starting dividend yield, plus …
  2. The growth rate of dividends, plus …
  3. A factor representing the change in valuation ratio (or the change in the dividend yield from the beginning to the end of the period)

Figure 3
Sources: WisdomTree, S&P, Bloomberg

The buyback ratio is a market valuation measure used to gauge what percentage of index market value is being reduced by share buyback activity of firms. The dividend and buyback ratio aggregates the dividends and buybacks together to represent a market valuation metric based on two common ways (dividends and buybacks) that firms distribute cash to shareholders.  


There are a number of takeaways from our analysis of dividend and buyback ratios on WisdomTree indexes and how they fit into the above formula for the markets.

The total return decomposition serves as a reminder about how one must constantly evaluate the trade-off between starting dividend yield and future growth rates of dividends when arriving at return expectations for a given market. Indexes that start out with higher dividend yields must rely less on an uncertain future growth of dividends.

When we look at what the dividend and buyback ratios foretell for the overall market valuation ratios, we see a fairly attractive picture. John Hussman was bearish quoting the S&P 500 with a dividend yield close to 2 percent. But this commentary points out that one must include analysis of share buybacks. When one adds that into the S&P 500 dividends, the combined dividend and buyback ratio is closer to 4.5 percent.

When we see the dividend and buyback ratio of the WisdomTree Dividend Index above 5 percent—and one adds on top of that any normal expectation for future dividend growth—we see a broad U.S. equity market that looks very reasonably priced. Moreover, WisdomTree's regional equity income indexes had combined dividend and buyback ratios of 5.5 percent to 5.9 percent, which represent to us even more attractive valuations for those indexes, especially when compared to the most common alternative asset class of choice: U.S. bonds.

Disclosures

You cannot invest directly in an index. Index performance does not represent actual fund or portfolio performance. A fund or portfolio may differ significantly from the securities included in the index. Index performance assumes reinvestment of dividends, but does not reflect any management fees, transaction costs or other expenses that would be incurred by a portfolio or fund, or brokerage commissions on transactions in fund shares. Such fees, expenses and commissions could reduce returns.

Endnotes

* Share buybacks are defined as a company using cash to repurchase shares from investors, thus reducing the company's shares outstanding.

2. The dividend yield of the S&P 500 is defined as index dividends per share divided by index price.

3. Hussman, John, "No Margin of Safety, No Room for Error," Oct. 11, 2010, http://www.hussmanfunds.com/wmc/wmc101011.htm

4. Source: Robert Shiller, http://www.econ.yale.edu/~shiller/

5. Share buybacks support higher prices because they reduce the shares outstanding for a company, and assuming the same total dividends or earnings, increase the per-share dividends or earnings of a firm. Assuming no change in the valuation ratios, the growth in per-share earnings or dividends should lead to a higher stock price.

6. The calculation aggregates buybacks per share times index shares divided by the index market value (price per share times index shares).

Additional index information is available at www.wisdomtree.com

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