Supporters of eliminating taxes on dividends argue that tweaking the internal revenue code will uncork a reservoir of dollar bills from corporate treasuries, where they’ve been gathering dust and low interest, and into the pockets of shareholders, where they rightfully belong. After all, despite all the woes afflicting corporate America, many highly profitable companies—especially technology companies—are practically choking on greenbacks. Microsoft has $40.5 billion in cash, Cisco has $21.2 billion, Intel has $11.2 billion, and Dell has $9.1 billion. Of those, only Intel pays a dividend, and it’s a measly 8 cents per share. Give these guys a tax-efficient means to part with their money, the reasoning goes, and they will.
Historically, these companies—and many like them—have preferred to channel cash to shareholders through stock buybacks. Intel spends about $4 billion each year on its own shares, while it pays out just $530 million a year in dividends. Dell last fiscal year spent $3 billion on stock buybacks and paid no dividend.
Conventional wisdom holds that buying back shares is good for shareholders. Many investors regard buyback announcements as signs of confidence, like chefs paying to eat at their own restaurants. The practice makes particular sense when shares seem beaten down for reasons unrelated to underlying performance. (Philip Morris has long been a major buyer of its own controversial stock.) Buybacks increase demand for stock, driving up prices. And by taking shares out of the public’s hands, buybacks make earnings-per-share look better, since there are fewer shares among which to divide profits.
But for many companies, purchasing their own shares is less a magnanimous gesture than a defensive one. They don’t buy back loads of shares each year simply because they want to, they eat the home cooking because they must—to compensate for all the options they give out. Regardless of what Washington decides about Bush’s tax plan, shareholders of Intel, Microsoft, Dell, and other cash-rich technology companies shouldn’t sit by their mailboxes waiting for fat dividend envelopes. The tax proposal may alter the incentives—the people who receive cash in buybacks will pay capital-gains taxes on the value realized, while dividend recipients won’t. But it won’t change the underlying dynamic that favors stock buybacks over dividend payouts.
An option gives its holder the right to convert it into a common share, subject to certain price and time constraints. Every option that a company issues to executives and employees is therefore a potential share, which, when exercised, adds to the total number of shares outstanding. Since the same earnings must be spread over a larger number of shares, any value realized by employees converting options into shares comes directly out of the value of existing shareholders. It’s a zero-sum game.
As options have morphed over the years from occasional incentives into a widespread form of compensation, many companies—not just startups like Amazon.com, but mature blue-chips like IBM—now find themselves with vast options overhangs. Dell has about 2.6 billion shares outstanding, but options exist on another 360 million shares—or 14 percent of the company.
To forestall the inevitable dilution caused by options, company boards authorize officials to buy back shares regularly. But if you’ve got lots of options outstanding, you can spend billions annually on your own stock and still not dent the total number of shares outstanding. It’s running in place. In the five-year period from 1998-2002, Dell spent $9.8 billion to buy back 940 million shares. But the number of shares outstanding fell by only 29 million.
Intel is another vivid example, in part because it is more transparent about its stock buybacks than many other companies. Since the second half of 1990, according to this chart, Intel has spent $28 billion to buy 1.6 billion shares. In recent years, it has spent almost exactly $1 billion each quarter, regardless of the price of the stock. From the beginning of 1998 through the middle of 2002, it spent $21.4 billion to purchase 740 million shares.
Despite the shopping spree—Intel has consumed more than 10 percent of outstanding shares since the beginning of 1998—Intel’s average number of shares outstanding has barely budged. At the end of 1997 the company had 6.542 billion shares outstanding; as of Sept. 30, 2002, it had 6.646 billion.
Could Intel afford to pay a higher dividend instead of buying stock? Sure. Let’s say it took the $4 billion it spent on its own stock last year and spent it on dividends. That would equate to a 68-cent-per-share dividend, a respectable 4 percent. Meanwhile, because it wouldn’t have been buying back all that stock, the number of outstanding shares would have risen by about 3.5 percent. With the company’s earnings spread over a higher number of shares, the net effect would have been a wash.
To a large degree, the focus on encouraging dividends is treating the right symptom but the wrong cause. The fact that companies use their cash to buy back stock instead of paying dividends has nothing to do with the way dividend payments are taxed. It has everything to do with the ways in which accounting practices have historically encouraged companies to pay their employees in options. Not having to report options as compensation on the balance sheet has made companies look healthier than they are.
A generation of investors has been schooled to believe that options are a comparatively cheap way for public companies to compensate their employees. Many of the recent scandals, in which executives motivated by short-term option grants took actions that hurt their companies’ long-term health, have taught us otherwise. The cost of stock buybacks is only the latest piece of evidence that options are, in fact, very expensive.