Dividend vs Buy Back. Which is Better ?

Dividend :- Companies Act 2013 defines the term dividend including interim dividend distributed among shareholders of the company. Dividend is basically, share of the profit (reserves) distributed by the company to reward their shareholders and to attract the investors. Generally, companies who distribute regular dividend to shareholders are considered favorable among investors.

Key Points :-

1. Dividend is not a guarantee payment. It depends on the company to distribute profit or to retain for further expansion.
2. Dividend can be revoke or reduce by the board of directors of the company.
3. Paying dividend shows good financial health of the company and its overall performance in its sector.
4. Dividend can be paid on Equity or Preference or both.

Types of Dividend :-

1. Final Dividend
• If dividend is declared in the Annual General Meeting (AGM) is called Final Dividend.
2. Interim Dividend
• If Dividend is declared between two AGM, i.e. declared before the AGM and gets approved by the shareholders in the AGM is called Interim Dividend.
3. Preference Share Dividend
• Dividend paid on the preference shares is called Preference Share Dividend.

Buyback of Shares :-

Buyback of Shares is a process by which company buys its own share at a premium from the market to reduce number of outstanding shares from the market. This is the way by which company reward its shareholders as company pays premium on the market price, i.e. company is paying more amount than the market price to the shareholders.

Why Buyback ?

Buyback helps company is following ways -

1. Buyback reduce the outstanding number of share resulting which higher EPS (Earning Per Share) and Lower PE Ratio (Price Earning Ratio) which attract the Investors in the market.
2. It is the way to earn attention of the shareholders as company is rewarding the existing shareholders by buying shares on premium.
3. Reducing risk of losing ownership and increased voting power to take decisions.
4. Increases the price of the share as supply reduces in the market through buyback.

Dividend vs Buyback - Example :-

Let’s use the example of a company that has 50 lacs shares outstanding. The shares are trading at say Rs 200 per share, giving a market capitalization of 10,000 lacs. Assume that Company had revenues of Rs 10,000 lacs in Year 1 and a net income margin of 10%, for net income (or after-tax profit) of Rs 1000 lacs or Rs 20 per share. This means that the stock is trading at a price-to-earnings multiple (P/E) of 10 (in other words, 200 / 20 = 10).

Suppose that Company wants to distribute its entire net income of Rs 1000 lacs to its shareholders. This could be done in one of two way as follows:

Scenario 1: 

Dividend :- Company pays out Rs 1000 lacs as dividends, which amounts to Rs 20 per share. Assume you are a shareholder and you own 1,000 shares of the company purchased at Rs 200 a share.

You therefore receive (1,000 shares x Rs 20/share) or Rs 20,000 as the special dividend. Since dividend less than 10 lacs is not taxable in the hands of individual shareholders, hence your return is (20000/2,00,000 = 10%) 10%.

Scenario 2: 

Buyback :- Company spends the Rs 1000 lacs buying back its shares. Although a company will execute its share buyback over a period of many months and at different prices, to keep things simple, we assume that Company buys back at a price of Rs 200 per share, which amounts to 5 lacs shares bought back or repurchased. This reduces its share count from 50 lacs shares to 45 lacs shares.

The 1,000 shares of Company that you purchased at Rs 200 will now be worth more over time because the reduced share recount will increase the value of the shares.

Assume that in Year 2, the company’s revenues and net income are unchanged from Year 1 at Rs 10,000 lacs and Rs 1,000 lacs respectively.

However, because the number of shares outstanding is now down to 45 lacs, earnings-per-share would be Rs 22.22 per share instead of Rs 20 per share.

If the stock trades at an unchanged price-to-earnings ratio of 10, shares should now be trading at:

Rs 222.22 (Rs 22.22 x 10) instead of Rs 200 per share.

What if you sold your shares at Rs 222.22 after holding them for just over a year. You would have gains of Rs 22,220 (i.e., (Rs222.22 – Rs200.00) x 1,000 shares = Rs22,220) and your effective return would be 11.11%(22220/200000=11.11%).

Which is Better ? - Final Thought:

1. After discussing in details, we can say that company have no opportunities available in the market since they distribute the profit either way Dividend or Buyback.
2. Buyback is more tax efficient way of rewarding shareholders but it takes more time to process.
3. Buying back its own shares could be a sign of confidence of a company in its prospects but if the shares subsequently slide, then that confidence could be misplaced.
4. Also dividend payouts do not have the flexibility that share buybacks have, as investors can choose the timing of their share sale and tax payment.
5. In dividend payouts, the investor has to pay taxes on them while filing tax returns.
6. But, it doesn’t mean that dividends payouts are a bad way of rewarding shareholders. In fact, there are some areas where the dividends are better than buybacks.
7. For starters, dividends offer complete transparency as information about the dividend payments are easily available through financial websites and corporate investor relations sites however the info on buybacks are very difficult to find.

Bottomline :-

If one is looking for building wealth over time then share buybacks could be better than dividend payouts because of the beneficial effect on the EPS from a reduced share amount. Nevertheless, both are very efficient ways of rewarding shareholders where a company can choose either one which is best suited for its shareholders and itself.

Happy Learning !!!