Investors ply their money in public limited firms to get an increase in their capital and income. There are a few methods by which a firm gives profits to its investors. This is through buybacks of shares and dividends in the form of cash. The reason that leads the firm to such strategic decisions on dividend vs. buyback hinges on a lot of elements such as the current share price of the firm, the long-term vision, the overall tax structure that is imposed on the firm and the investors, the goal that the firm wants to convey to its shareholders, the opportunities of investment, and more. In this article, we will look at whether buyback or dividend is a better method for the investors and the firm.
The shares that pay dividends give profits that the firm wants to share with its investors. The dividend is an amount of money paid out from the profits that the firm is going to make over a period. There are several firms that decide to give dividends on an annual basis. Some pay out the same on a bi-annual or quarterly basis. An investor must keep in mind that the payout of dividends is not always guaranteed. This is because they are hinged on the firm's profits in a given period. The board of directors of the firm decides whether the firm is going to pay out any dividends in the near future. Even if the firm is earning good profits, the dividends may not be paid out to any investor. Instead, the gains made by the firm are invested in the expansion and growth of the firm. Any dividends that are more than a certain amount by any firm are also subject to the appropriate taxation in the hands of the investors.
The process of buying back shares is a complete corporate action. Under this method, a firm will buy back the shares that have been issued to the investor in the past. The shares are purchased at a slightly greater cost than their current price in the market. This is a method in which the firm chooses to reward its investors. The premium given in this method encourages the investors to go for the process of the buyback. When the firm opts for the buyback of shares, the number of shares that are outstanding in the market comes down. When this happens, the firm pays out a tax. The investors are also taxed for the capital gains that they get. The buyback of shares happens in a couple of ways. The shares can be purchased directly from the shareholders. Under this method, there will be no implications of any securities transaction tax. But any capital gains tax will be levied. If the capital gains are for the short term, then the shareholder will be taxed as per the appropriate income slab.
In the situation where the capital gains are for the long term, the long-term capital gains tax will be imposed as per the income slab. The buyback of shares can also happen through the financial markets.
When considering buyback or dividend, the dividends paid out in cash give a regular stream of cash for the investors of the shares. It permits the investors to remain invested in the firm and get greater cash flows. The dividends received can also be a huge incentive for investors who tend to rely a lot on their investments to meet their overall expenses of living. This includes retired investors who may not have any other source of income. The size of a payout of dividends is usually smaller compared to a buyback. So, it permits the firm to keep a conservative capitalization structure in each quarter rather than sitting on a large amount of cash.
The method of the buyback is very good in returning the capital back to the stockholders and keeping the taxes low. This is because the investors do not have to experience additional tax on the overall process. The tax is only applicable when the investor's actual sale of the stocks happens. But when seen as dividend vs. buyback, the former attracts a substantial amount of tax. In several nations, the payments of dividends also come with a dividend distribution tax. This means that in addition to the dividend paid to the investors, the firm must pay a similar amount to the Government in taxes. This leads to firms choosing buybacks instead of dividends in those nations. The method of buyback also avoids a decrease in the value of a share by decreasing the supply of the share. With the decrease in the outstanding shares, the firm's earnings per share boosted. This is a great indication of the firm's profitability and boosts the prices of the shares in the long run. The buyback of shares is utilized as a strategy by the firm's management to indicate its confidence in the firm and give a message that the shares are undervalued.
For instance, if a share is trading at twelve dollars and the firm announces that it will initiate a buyback at fifteen dollars, it will immediately develop a value for its stockholders. The prices will start moving upwards. It helps the firm utilize excess cash lying around because of a lack of chances. The idle cash gets no additional income for the firm. This is valid for firms such as Apple that have a lot of excess cash. Suppose the promoters do not take any part in the overall process of the buyback. In that case, it increases the holdings of all the promoters and prevents any takeover by opponents. It also gives the firm management more control and improves the overall decision-making process. This is because there are not as many shares owned by the investors after the buyback process. For instance, to address the issues related to overall decision making, Google developed a couple of classes of shares. One of the classes had voting rights, and the other had no such rights.
The dividends give cash to all the investors. But the buyback of shares gives back the cash to investors chosen by the firm. So, when a firm pays out dividends, every investor gets cash according to the overall proportion of their holding. This is valid whether they are in any need of cash or not. But in the case of buyback of shares, the investors choose whether they would like to take any part in the process or not. The buyback of shares also gives the investors the chance to change their shareholding pattern. Greater earnings per share would also lower the overall price-to-earnings ratio. This development is seen in a positive light in the financial markets. So, higher earnings per share and a lower price earnings ratio should greatly impact the price of the shares. The buyback of the shares also gives a lot of liquidity chances for a thinly traded stock.
The debate in this article on dividend vs. buyback gives some very interesting points for choosing the best capital structure based on valuations and the shares' prices. And more. But it seems good to conclude that the latter won the fight in the dividend vs. buyback matchup, excluding a few factors. The method is a great one for both investors and firms. The process of the buyback is a little costly and tedious. This is because it involves a lot of approvals and filing from the financial markets. The firm and the investors gain a lot from the offer of buyback. This makes it a great option for both parties. After discussing both of them for dividend vs. buyback, all investors should keep in mind that buybacks should not be done for any ulterior motives. It should not send any incorrect signals and develop confusion in the minds of the investors. After all, this is the era of good corporate governance.