In their famous 1961 paper, “Dividend Policy, Growth, and the Valuation of Shares,” Merton Miller and Franco Modigliani theorized that investors should be indifferent about whether they receive distributions via dividends or buybacks, as well as how they participate in a buyback (either by receiving cash from tendering their shares or by receiving an increased proportion in the company).
Despite the acceptance of the theory, buybacks generally have been ignored when examining stock returns. This is despite the fact that, since the 1980s, corporations have been increasing their use of buybacks. This structural change in corporate payout policy coincided with the adoption of SEC Rule 10b-18 in 1982, which offered a safe harbor for companies to conduct share buybacks without being suspected of share price manipulation.
The change in payout policy has been so dramatic that in eight of the 10 calendar years over the period ending in 2014, buybacks actually exceeded dividends. There are two obvious explanations for the increased use of buybacks. The first is the increased use of options as a form of executive compensation. Because dividends reduce the stock price in a way that buybacks do not, corporate executives naturally favor buybacks.
The other explanation is that, for taxable investors, buybacks are a more tax-efficient way of earning a return. Given that buybacks should have the same impact as dividends on returns, ignoring them when forecasting expected returns could lead to the underestimation of those future returns.
New Research On Buybacks
Philip Straehl and Roger Ibbotson contribute to the literature with their study “The Long-Run Drivers of Stock Returns: Total Payouts and the Real Economy,” which appears in the third-quarter 2017 issue of the CFA Institute’s Financial Analysts Journal.
The authors observe that “buybacks have a fundamentally different impact on the return generation process than dividends do. Although payouts via dividends increase the income return, buybacks increase the price return (per share) because a buy-and-hold investor’s share in a company is increased.”
They then explain that traditional return models are often wrongly applied in practice because investors tend to combine current dividend yields with historical per-share growth rates when forecasting expected returns. This can lead to underestimating forward-looking per-share growth because buybacks increase a buy-and-hold investor’s proportion in the company over time. In other words, buybacks increase per-share growth. Examining data from 1871 through 2014, Straehl and Ibbotson found:
- Total payouts per share (adjusted for the share decrease from buybacks) grow in line with economic productivity. Aggregate total payouts grow in line with aggregate GDP—total payouts participate in the growth of the real economy. From 1901 through 2014, aggregate total payouts and GDP grew at roughly the same annualized rate: 3.27% and 3.36%, respectively.
- By ignoring buybacks, the dividend discount model (DDM) significantly underestimates the forward-looking equity return when the current yield is combined with historical growth.
- For the period 1970 through 2014, including share buybacks along with dividends in the payout terms dramatically raises the payout yield from 3.0% (dividend yield) to 4.3% (total yield), highlighting the important role buybacks have played in returning cash to shareholders in recent decades.
- The cyclically adjusted total yield is at least as predictive of changes in forward-looking expected returns as the cyclically adjusted price-to-earnings (CAPE 10) ratio.
The authors concluded: “The total payout model represents a viable alternative to such traditional supply models of stock returns as the DDM, providing a framework for deriving macroconsistent forecasts of long-run stock returns as well as superior forecasts of short-term expected returns.”
When they examined data as of the end of 2014, Straehl and Ibbotson found that, while the DDM provided a forecast for expected real stock returns of 3.63%, the total payout model provided an expected real return forecast of 5.11%, a difference of almost 1.5 percentage points.
The structural shift in payout policies that occurred in the 1980s clearly has impacted how investors receive returns. Yet this shift has tended to be ignored by those using the DDM to forecast expected returns. Straehl and Ibbotson show that, when estimating future returns, investors should not ignore this increasingly important source of shareholder return.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.