In this article, FinTuts will share its views or insights about the basics of Dividend vs Share Buyback from an Investor perspective, so that you can take a self-decision on your investment or wealth creation journey and can be financially literate and atmanirbhar.
When it comes to the stock market, there are two ways in which companies offer rewards to their investors – Cash Dividends and Share Buyback. Many stock market companies provide both to make their shareholders happy.
From a dividend declaration perspective, the company can be considered to be cash-rich and it is a sign that the company is making good money. From a share buyback perspective, the number of outstanding shares of the company goes down, and therefore it can be concluded that the earnings per share will increase.
The generic difference between dividend payment and share buyback would be that the dividend provides a definite return, whereas a share buyback provides an uncertain future return.
The basics of Dividend vs Share Buyback
A cash dividend is a payout or division of profits by the company to its shareholders from time to time, be it annually or after any other duration. It gives a hint that the company is performing well and that it is willing to distribute the rewards to its investors. However, dividends are not guaranteed.
A higher dividend payout also results in a higher dividend yield which can be considered as the important metrics of a stock valuation apart from P/E and P/BV ratios.
In a buyback, the company buys back its own shares from the existing shareholders at a premium to the market price and that becomes profitable to shareholders.
Generally, there are two positive fallouts of a buyback: the reduction in the number of outstanding shares that increases the EPS of the company and interpreted as an indication that the company has the confidence to buy the stock at a certain price that acts as a psychological base price for the stock.
Market Trends on Dividend vs Share Buyback
In recent times, market dynamics have really changed and a surge in the announcement of buybacks has been noticed.
Share buybacks have become a lot more prominent and really big in a way that has actually substituted cash dividends in the recent past, because till March 2020 DDT(dividend distribution tax) was very high. After that, the same tax has been passed on to the shareholders and it is still a little more beneficial for promoters to go for a share buyback.
The following reasons play an important role in why the share buybacks have been preferred by companies over dividend payment in recent times: Tax implications of cash dividend, Improved EPS(earnings per share) valuation, price stabilizer, etc.
Taxation aspect of Dividend vs Share Buyback
- Regarding dividend payouts, it is taxed as per the current tax slab since April 2020.
- In case of share buyback, tax is deferred until the shares are sold.
Dividend vs Share Buyback Scenario
Let’s take an example of a company that has 10 lacs shares outstanding, share price at Rs 100 per share, hence, a market capitalization of 1,000 lacs. Assume that company had revenues of Rs 1,000 lacs in Year 1 and a net income margin of 10%, for net income (or profit after-tax) of Rs 1,00 lacs or Rs 10 per share. This means that the stock is trading at a price-to-earnings multiple (P/E) of 10 (in other words, 100 / 10 = 10).
Suppose that Company wants to distribute its entire net income of Rs 1,00 lacs to its shareholders. This could be done in one of two way as follows:
Instance 01: Cash Dividend
Company pays out Rs 1,00 lacs as dividends, which amounts to Rs 10 per share. Assume you are a shareholder and you own 1,000 shares of the company purchased at Rs 100 a share.
You therefore receive (1,000 shares x Rs 10/share) or Rs 10,000 as the special dividend.
Instance 02: Share Buyback
Company spends the Rs 1,00 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, let’s assume that Company buys back at a price of Rs 100 per share, which amounts to 1 lac shares bought back or repurchased. This reduces its share count from 10 lacs shares to 9 lacs shares.
The 1,000 shares of Company that you purchased at Rs 100 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 1,000 lacs and Rs 1,00 lacs respectively.
However, because the number of shares outstanding is now down to 9 lacs, earnings-per-share would be Rs 11.11 per share instead of Rs 10 per share.
If the stock trades at an unchanged price-to-earnings ratio of 10, shares should now be trading at: Rs 111.11 (Rs 11.11 x 10) instead of Rs 100 per share.
What if you sold your shares at Rs 111.11 after holding them for just over a year. You would have gains of Rs 11,110 (i.e., (Rs111.11 – Rs100.00) x 1,000 shares = Rs11,110)
The Bottom Line | Verdict
- Cash Dividend and Share Buyback, both options can be considered as a great way of rewarding the shareholders by companies when they have surplus cash.
- For investors who are looking for a regular income may choose the dividends option and investors who are looking for a long-term gain may choose buyback options.
We hope that this article might have surely helped you to understand in general about the basics of Cash Dividend vs Share Buyback from an Investor perspective in Indian stock market.
If you liked reading about this article, please do visit our other articles regarding Mutual Fund or Passive Income related reviews.
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