InvestorQ : How do you compare dividends and buybacks as means of rewarding shareholders?
rhea Babu made post

How do you compare dividends and buybacks as means of rewarding shareholders?

2 years ago

Let us first look at both these methods of rewarding shareholders individually and then take a combined view.

What is a dividend and what does it indicate

A dividend is a cash payout by the company and is one of the best indications that the company is actually making money and is also cash rich. Taxes and dividends are two areas where you cannot lie as the actual payout has to be made in both the cases. Dividends give a hint that the company is performing well and that it is willing to distribute the rewards liberally to the shareholders. A higher dividend payout also results in a higher dividend yield. This is critical as dividend yield is the 3rd important metrics of valuation apart from P/E ratio and P/BV ratio. A high dividend yield ratio is considered to be a signal of a stock being underpriced and acts as a defence for the stock falling below a threshold level. Above all, dividends give an indication that the company is performing well, it is growing and it is actually cash flows on hand.

What is buyback and what does that indicate?

In a buyback the company buys back its own shares. It is one more way of rewarding the shareholder apart from dividend. Shareholders are able to tender their shares in the buyback and get their money back. Most buybacks are done at a premium to the market price and that becomes profitable to shareholders. Take the case of Infosys. The stock is quoting between Rs.900 and Rs.950 but the buyback price has been set at Rs.1150 leaving a clear upside margin for shareholders. There are two more positive fallouts of a buyback. Firstly, the buyback leads to the bought back shares being extinguished. Thus the number of outstanding shares reduces and that increases the EPS of the company. That is likely to be value accretive. Secondly, when the company commits to buyback the stock at a certain price, it is interpreted as an indication that the company has the confidence to buy the stock at that price. That acts as a psychological base price for the stock.

Their tax treatments are different till Budget 2019

This is perhaps the most important factor that determines the choice of a company; whether to go for a buyback or a dividend payout. In the Indian context, dividends are subject to taxation at 3 levels. Firstly, dividend is a post tax appropriation and hence the tax shield is not available to dividends. Secondly, when companies pay out the dividends, there is a dividend distribution tax (DDT) that the company has to pay on the dividends paid out. To that extend it reduces the dividend payable to the shareholder. Effective the Union Budget 2016, there is an additional complication. All shareholders who receive more than Rs.1 million as equity dividends each year will also have to pay an additional 10% tax on the dividends received by them. These 3 levels actually make dividends quite tax-inefficient for the shareholders. Of course, the small shareholders are not really impacted but large shareholders with substantial holding are surely impacted. For them the buyback is more meaningful as it is also tax efficient considering that long term gains are tax-free in the Indian context. Of course, things have changed because in Budget 2018, long term gains became taxable at 10% and in Budget 2019, buybacks were made taxable at the rate of 20% of the difference between buyback price and issue price. That largely takes away the attractiveness of the buyback route over the dividend route.

How do dividends versus buyback impact valuations

Ironically, both buybacks and liberal dividends are seen as indicative of a company that does not have too many productive investment opportunities left in the market. As a result, both these tend to impact valuations negatively or are at best neutral to valuations. Take the case of dividends. If you browse through the list of PSU stocks with high dividend yields, most of them quote at fairly salivating valuations. It is just that investors tend to prefer growth over payouts and growth reflects more emphatically on valuations. That explains why a stock like D-Mart or Eicher gets such handsome valuations despite having such a low dividend payout ratio. When it comes to buyback there is another interesting aspect. The reduction in the shares outstanding boosts the EPS but then the P/E ratio tends to get downgraded as a result of which the impact on stock price is either neutral or negative.

It is found that during normally markets, the dividend stocks and the buyback stocks tend to perform based on fundamentals. However, in down markets, the dividend stocks tend to outperform the benchmark indices and the buyback stocks. After all, in a bad market it is finally cash that is the king.