Cash dividends and share buybacks are two main ways in which a company rewards its shareholders. In recent times, we’ve seen many big companies like TCS, HCL, and Wipro announcing buybacks. Most companies shifting towards the buybacks after the Union Budget 2016 which made dividends above Rs 1 million taxable at 10 percent. Since then there has been a major shift towards buybacks. Even when the TCS announced the second buyback of shares worth Rs 16,000 cr., the questions raised once again on how should companies in India reward its investors – By paying dividends or by buying back its own shares?
However, rewarding by paying dividends or buying back shares totally depends upon company to company and several factors such as current stock price, tax structure applicable to its investors and to the company.
So, which one is better – dividends or buybacks?
Before we make any decision let’s analyze the situation and discuss both ways one-by-one.
What are Dividends?
Dividends are like a bonus to investors which distributed as a share of company’s profits on the quarterly or monthly basis. It is a rewarding way for companies to offer dividends from after-tax profits to their shareholders. For example, if a company pays a cash dividend of 1 rupee per share, an investor with 100 shares would receive 100 rupees in cash. But, if a company is paying a 10 percent stock dividend then an investor who has 100 shares, will have 110 shares after the stock dividend.
Dividends are not guaranteed. It’s all depends upon the board of directors of a company. Unlike, bonds, the board of directors can decide to reduce or cancel dividends at any time.
Then why do people invest in dividend stocks?
Even though the dividends are not guaranteed yet many people still rely on the dividends as a steady income source. Retirees who looked for steady income source create a schedule to receive dividend check on the monthly or quarterly basis, however, the young investors who may not require the income now – can put those dividends checks by reinvesting them for portfolio growth.
But, why do companies pay dividends?
Paying timely dividends indicates the financial health of a company and its overall performance in its sector. Companies use this strategy to attract their investors to keep investing in them.
What are Buybacks?
The buyback is a process of reducing the number of shares outstanding for a company by purchasing its own shares from the marketplace. In doing so, the company purchases its own shares from the shareholders by offering a premium on current market price. This premium is a rewarding way of a company to its shareholders, which incentivizes them to take part in the buyback process. To better understand this, let’s take an example of Infosys where the stock is quoting between 900 and 950 rupees but the buyback price has been set to Rs 1150 leaving a clear margin for its shareholders.
A company takes this step when it feels like shares are undervalued and as to increase the value of remaining shares available by reducing the supply. Another reason for the buyback is compensation. It has been seen that companies often reward their management and employees with stock rewards and stock options. By purchasing their own shares, companies issue shares to their management and employees. This action was also taken by the company to increase the stock price of undervalued stock also helps in increasing earnings per share (EPS), cash-flow-per-share and also improves performance measures like return on equity (ROE).
So, how companies perform a buyback?
Usually, buybacks carried out in two ways –
- First, shareholders of a company presented with a tender offer where they have the option to tender or submit, all or a portion of their shares.
- Second, company buyback shares in the open market.
All this is to prevent the decline in the value of the stock by decreasing the supply.
Dividends vs. Buybacks – How are they Tax Differently?
This is one of the important factors to consider while deciding for which is better – dividends or buybacks. In our country India, dividends are subject to taxation at 3 levels –
- Since the dividend is a post-tax appropriation thus the tax shield is not available to dividends.
- Second, there is a dividend distribution tax (DDT) that the company has to pay on the dividends paid out. This second-stage tax reduced the dividend payable to the shareholder.
- Third, according to the Union Budget 2016, all shareholders who receive more than Rs 1 million as equity dividends each year will also have to pay an additional 10 percent tax on the dividends received.
These three stages of taxes make dividends quite inefficient from a taxation point of view. In here, the buybacks are tax-efficient for small investors considering that long-term capital gains (LTCG) are tax-free in India.
Which is Better: Dividends or Buybacks? – Final Thoughts
By discussing both aspects of rewarding shareholders, both dividend payouts and buybacks are seen as indicative of a company who does not have any productive investment opportunities left in the market. Corporate buybacks may be regarded as a tax-efficient way of rewarding shareholders but timing is very critical for buybacks to be effective. 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. Besides, the dividend payouts do not have the flexibility that has in share buybacks where investors can choose the timing of their share sale and tax payment. In dividend payouts, the investor has to pay taxes on them while filing tax returns.
But, it doesn’t mean that dividends payouts are the absolutely rubbish idea of rewarding shareholders. In fact, there are some areas where the dividends are better than buybacks. For starters, dividends offer complete transparency where the 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.
If one is looking for building wealth over time then share buybacks could be better than dividend payouts for investors 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.
Hope, you find this article helpful. If you have any query or would like to add something then don’t forget to mention in the comment section below.
Note: All information & data provided in this article is for the educational purpose as well as to give general information on the finance & economy, not to provide any professional advice or service. Views & opinions are not biased against the company and do not affect any official policy or any other agency, an organization within the content.