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)