In our last articles, we have discussed what is payout ratio, DPS and stock repurchase. In this article, we will be discussing the difference between cash dividend and share buyback, which one is better for investors.
A company with surplus cash has following three options to reward shareholders:
- Pay cash dividends to shareholders,
- Share repurchase or buyback.
- Invest most or all of earnings back into the company for expansion or acquire another company to expand business.
Its not mandatory that company has to adopt any one strategy to maximize shareholder’s wealth. Based on different factors, company can combine all the strategy or a combination of one or two. For instance, companies can pay regular cash dividends supplemented by share repurchase.
Company can decide to return excess capital to shareholders by repurchasing outstanding shares and destroying it. This is also known as buyback of shares. Existing shareholders who wants to participate in stock buyback can surrender stocks in proportion to their eligibility to receive cash from the company. After repurchasing stocks, company pull them out of circulation and destroy them.
Due to share repurchase, number of outstanding shares will be less, resulting in a larger percentage of ownership in the business for remaining shareholders.
Dividends are a share of earnings that a company pays at regular intervals to its shareholders out of after-tax profit.
After receiving dividend, shareholders also include it to their income for income tax purposes. This means dividend is effectively taxed twice; first company pays tax out of its profit and then in the hands of shareholders when dividend is received.
One of the biggest advantages of share repurchase is we do not have any additional tax on it. It also increases earnings per share, cash flow per share and return on equity.
However dividend has its own advantages. Cash dividends can be a great help for a retired person or for someone who is looking for regular flow of funds to his bank account.
Dividend payout and share repurchase policy can be understood from company’s payout policy. Both share buyback and dividend is funded out of corporate profits. Therefore, share repurchase and dividend payments are two forms of returning company’s profit to shareholders.
A company can use both dividend and share repurchase to reward shareholders. For instance, if a company wants to return 80% of its earnings to shareholders by keeping 45% as their dividend payout ratio, then they can do so by paying 45% as dividend and return the other 35% in the form of stock buyback. A combination of buyback and dividends can significantly increase returns for shareholders.
Now you can decide which one is better for you. For us, the answer to the question “cash dividends or share buyback – which is better for investors?” is simple, it depends.