Last Updated Aug 10, 2011 9:43 AM EDT
Cash returned to shareholders
There are two ways a company can act in its shareholders' best interests and return cash to shareholders. The first is dividends and the second is buying back its own stock.
The current dividend yield of the S&P 500 is about 1.89 percent. This alone happens to nearly twice the 5-year Treasury is yielding. It equates to about $196 billion of the approximate $10.7 trillion total value of the 500 companies.
These companies also returned nearly $90 billion in the first quarter of 2011 via stock buybacks. Continuing at such a pace would equate to $359.4 billion or about 3.37 percent. This combined with the 1.89 percent dividend yield gives an estimated 5.26 percent cash yield.
Why a stock buyback is as important as dividends
When a company pays a dividend, shareholders must pay taxes irrespective of whether the shareholder reinvests or not. By buying back its own stock, the company allows the shareholder to decide on who wants the taxable consequence.
If you think about it, the economic consequences are virtually the same for shareholders regardless of how the company returns cash. Take an example of owning 100 shares of ExxonMobil who decides to buy back three percent of its shares. You can sell three shares back to the company (or anyone else) and reap the exact same benefit as if they had paid you an additional three percent dividend. You can take that cash to the bank and your percentage ownership in the company would remain unchanged. You'll own three percent fewer shares and ExxonMobil will have three percent fewer shares outstanding. You would, however, be taxed at a higher rate if you held the stock for a year or less.
Is the 5.26 percent cash yield sustainable?
One reason companies often buy back their own stock rather than pay dividends is that their stocks are punished far less by lowering stock repurchases than cutting dividends. Thus stock buy backs will be more volatile than dividends.
But there are a few things that make be believe this 5.26% yield is sustainable.
1. The current earnings yield of the S&P 500 is about 8.8 percent, according to Standard and Poors. Thus, companies can return cash and still have funds to reinvest for growth. Don't lose site of the fact that earnings were good in the second quarter of 2011.
2. The 500 companies have about $1.1 trillion of cash. Though much is overseas, this is a ton of cash they can use to buy stock.
3. Earnings appear real this time. In 2006 and 2007, much of the earnings were from accounting tricks from financial institutions. Today, financials make up a small part of the earnings and there is nothing like cash on the balance sheet to show its real.
4. The recent stock market decline makes the share repurchases more attractive as the companies can buy more shares at a lower price.
I'm not smarter than the market but the recent 15 percent off sale has made the cash yield of stocks look pretty attractive to me. Companies appear to be doing the right thing and returning most of their cash earnings to the shareholders. This, combined with the paltry yields from US Treasuries, makes me think stocks are very attractive now.
Author's note: I used the S&P 500 only because I could only find data on these stocks. I continue to recommend buying total index funds.