In a recent white paper, famed investment thinker Michael Mauboussin raised an interesting question to shareholders, “If you own the shares of a company because you believe the stock is undervalued, why would you ever want the company to pay a dividend instead of buying back shares? Most shareholders will say, why not receive a tangible bird in the hand now in the form of a dividend instead of waiting for value that may or may not surface.

Finance professors will tell you that rational shareholders should be indifferent when it comes to a dividend vs. a share buyback. When receiving a dividend, the shareholder has to pay tax on the income and then make the tough decision of how to allocate the capital in the most efficient manner. A share-buyback removes the capital allocation decision from the shareholder, defers the tax and in due course should lead to a higher share price. Well that’s all well and good a shareholder will say to a finance professor but look at all those high tech companies like Cisco and Microsoft that were buying back shares hand over fist many years ago when their stock prices were double what they are today. That was not an efficient use of capital and we would have been better off getting the cash in the form of a dividend.

So how does a shareholder know if their company is allocating cash efficiently? What metric should an investor look at to know if a company should be increasing its dividend or ramping up its share buyback program. The answer comes down to figuring out what constitutes an undervalued share price. In our mind, the formula is pretty simple. A company should only buy back its stock when its Price Earnings ratio (P/E) is less than its Return on Equity (ROE). ROE is how much income a company is earning from each dollar of equity invested in the firm. A P/E ratio is how much the market is willing to pay for a dollar of a company’s earnings. If the market is willing to pay more for a dollar of company earnings than the company can earn on its equity, then that dollar would be wasted on share buybacks and excess cash should be returned to shareholders. If the market underappreciates a company’s earnings power by assigning it a P/E ratio less than a company’s ROE, then buybacks are not a waste of the shareholder’s capital.

Being cheapskates (we prefer the term value investors), we prefer to buy companies where the P/E ratio is less than 75% of a company’s ROE, essentially buying a dollar for 75 cents.

Three companies that have attractively allocated shareholder’s capital to share buybacks are (P/E and ROE are based on consensus estimates for 2012).

CSX Rail       P/E 11.7 ROE 19%

Viacom         P/E 13.5 ROE 29%

Tim Hortons  P/E 18.3 ROE 35%

Disclosure: The author owns shares in Viacom and Tim Hortons. Clients of Baskin Financial own shares in all three companies mentioned above