There are two ways company can give out its profit to shareholders. One is to give out dividends. The other is to buy back its own stocks. Which one is more appropriate? This article will explore the topic further.

The American tax law give a slight edge to stock buybacks. It is taxed once before the company decide to use its profit for stock buyback. (Every profit in a corporation is normally taxed). Dividend payment meanwhile is taxed twice. Once when the corporation reports a profit. Twice, when the shareholders receive it as an income. Most recently, investors receiving dividend income are taxed at rate of 15%.

So, does stock buy back is always advantageous to dividend payment? No, not really. It really depends on what price the company buys its own stock. If a company buys back its stock when the stock price is relatively overvalued, then it is better to distribute it as dividends. Shareholders can then appropriately invest it in undervalued investments.

So, at what point will dividend make much more sense? This all goes back to the fair value of the common stock itself. In a 4.5% interest rate environment, stock trading at a fair value is yielding 7.5% ( a Price Earning Ratio of 13.3 ). This assumes a 0% growth in earning. Therefore, it is desirable for companies to buy back its stock at a P/E of 13.3 or less.

But, wait. Since, dividend is taxed at a 15% rate, company that buys back its own stock at fair value will still saves shareholders 15%. Therefore, buyback still reward shareholder even when the common stock is 15 % overvalued. Based on this, company should continue buying back its stock only when the stock is trading at a P/E of (115% x 13.3) = 15.3. For a 0 % growth, it makes no sense for management to insist on buying back its stock that is trading at a P/E higher than 15.3.

One recent example is Intel Corporation (INTC) which initiates a $ 25 Billion intelligent stock buyback on Thursday Nov 10th 2005. At current price of $ 26.16 and $ 2.24 positive net cash on the balance sheet, Intel is buying back its stock at a forward P/E of 16.72. While this is a high P/E to buyback stock for a company that is not growing, Intel is not a 0% growth stock. Analysts generally expect Intel to grow its earning by 15.5% for the next five years.