Dividends versus buybacks – which is a better choice?

Guide To Fundamental Research | Published on 29th June 2018 | 343

When TCS announced its second round of buyback of shares worth Rs.16,000 crore, it has once again raised the debate on how should companies in India reward shareholders. Broadly, there are two ways of rewarding shareholders viz. dividends and share buybacks. After the Union Budget 2016 made dividends above Rs.1 million taxable at 10% in the hands of the investors, there has been a major shift towards buybacks. At least, large companies with a cash pile prefer to reward shareholders with buyback of shares rather than through dividends. First a word on both these methods of rewarding shareholders!

Dividends versus share buybacks

Dividends are distributed by companies out of their profit after tax. It is a post-tax appropriation. Dividends are cash payouts and to that extent they reduce the value of the company. When we talk of value we refer to the net worth of the company and the market value. Both reduce to the extent of the dividends paid out. Normally, companies that do not have too many investment projects to invest in will prefer to payout the profits as dividends to shareholders. A buyback, on the other hand, is a reduction of capital. In India buying back shares for treasury operations is not permitted, unlike the US. A buyback of shares has to be necessarily for extinguishing capital only. Since buyback reduces the outstanding capital, your profit is distributed across fewer shares and that improves the EPS of the company.

Which is a better choice – Dividends versus share buybacks?

Let us consider the choice of dividends versus buybacks across some key parameters:

  • The first way to compare the buyback of shares with the dividend method is based on the tax implications. Here is where buybacks definitely score over dividends. When a company declares dividends, there is a dividend distribution tax (DDT), then dividends are taxed at 10% above Rs.1 million in the hands of the investors. Let us not forget that dividends are a post tax appropriation, which makes it 3 levels of taxation on dividends. If buybacks are conducted through the market mechanism then they will be treated as long term capital gains. Even if you consider the 10% tax on the LTCG, it works out more economical than paying out the cash as dividends.
  • How do dividends and buybacks compare as a signal of valuation? Here again buybacks score over dividends. When a company is willing to buy back the stock at a certain price it is normally treated by the market as a base below which the price will not fall. Practically, this need is not always true as we have seen in the case of companies like PC Jewellers. For more stable names, companies do use buybacks to signal that the stock is undervalued, although that may not be the case. In case of dividends, there is no such signal that comes out from the announcement, although at an overall market level, dividend yield does act as a price support for the index.
  • Finally, what adds more value to shareholders? Both, dividends and buybacks are signals to the shareholders that the company is sitting on excess cash. Should shareholders take more cash in the business as a positive signal? Let us take the case of dividends first. When a company increases its dividend yield, you normally get to see the company’s P/E reacting negatively. That is because higher dividends are seen as a signal that there are not too many growth opportunities in the company. Since shareholders pay for growth, a higher dividend payout does not help valuations. That explains why OMCs quote at low valuations despite generous dividend payouts. The same logic applies in case of buybacks too. When shares are bought back, it is seen as a business with too much cash and limited investment opportunities. That reduces the P/E of the company and negates any benefit from higher EPS post buyback.

Let us also understand buybacks from the perspective of the promoter, since there have been quite a few cases in the recent past. As a means of consolidating the stake of promoters in the company, buybacks can be more useful. For example if the company has a share capital of Rs.100 crore and let us assume that the promoters hold 30% stake. If the company uses its cash reserves to buyback 10% of the capital, then the company’s outstanding capital reduces proportionately. That takes the stake of the company up from 30% to 33.33%, if the promoters do not participate in the buyback. Dividends do not have any impact on the shareholding pattern of the company.

Dividends and buybacks have emerged in India as key means of rewarding shareholders. While buybacks are more tax efficient, there are some critical corporate governance issues that have to be taken care of. Overall, valuations in India are still driven by growth. The irony is that neither buybacks nor dividends are indicative of growth prospects of a company.