Dividend vs share buyback: Which is better?

Dividend vs share buyback: Which is better?geralt / Pixabay

For well over a century, dividends were the preferred means for corporations to return excess cash to their shareholders. But companies began focusing more on share buybacks in the 1980s to return capital to shareholders. According to Morningstar, stock buybacks have now surpassed dividends as the means to return excess capital to shareholders. In this dividend vs share buyback comparison, let’s check out how they differ and which is better.

Many companies use a combination of stock buybacks and dividends to make their stakeholders happy. A company analyzes several factors such as its current stock price, applicable taxes, investment opportunities, its long-term vision, and its message to investors to decide whether to reward shareholders through dividends or buybacks.

Dividend vs share buyback explained

Cash-rich companies distribute part of their after-tax profits as dividends to their shareholders. They distribute dividends – a specific amount per share – to all shareholders for showing faith in the company and holding its shares. All eligible shareholders get a dividend amount in proportion to the number of shares they hold.

Companies don’t distribute all their profits as dividends, though . They keep a certain amount for R&D and other business needs. Excessive dividend payouts can hurt the company’s long-term growth. So, they restrict dividend payments to the amount they don’t need for reinvestment, R&D, and expansion.

Dividends, especially when reinvested, can significantly boost your long-term returns. For many investors such as retirees, dividends are a regular source of income. Investors are inclined to put their money in businesses with a long history of paying healthy dividends. Retirees and other investors can use dividends to pay their bills without having to worry about the short-term volatility in the stock market.

Dividends are taxed differently in the US. There is an additional 15% tax on dividends to shareholders. It’s something you need to consider before investing in high dividend stocks.

Once companies start paying dividends or increase the payout, it becomes difficult for them to cut dividends. Reducing dividends could signal investors that the company is not doing well financially. It encourages the management to be more responsible with the capital. It also prevents the management from hoarding large piles of cash.

Share buybacks

In the last few years, companies are increasingly using stock buybacks as a way to return cash to shareholders. In the share buyback process, a company uses the excess cash to purchase its own shares in the open market or directly from shareholders. The company fixes the amount earmarked for buybacks, the buyback price, as well as the offer period.

Generally, the buyback price is set at a premium to the current market price. It incentivizes investors large and small to participate in the buyback program by selling their shares to the company. Companies often buy back their own shares when the management feels that the stock is undervalued.

It’s important that investors pay attention to the price at which a company buys back its shares. Repurchasing shares in a bull market at sky high valuations will not be that accretive to earnings in the long run.

Buybacks reduce the total number of outstanding shares. After the buyback, each remaining share has a greater percentage ownership in the company. It boosts the share price as well as earnings per share (EPS). It makes it easier for the company to meet or exceed analysts’ expectations.

Buybacks gained momentum in 1982 after the enactment of Rule 10b-18. The rule allowed corporate management to repurchase shares without facing stock price manipulation charges. Share buybacks are more tax-efficient than dividends as a means to return capital to shareholders. While dividends are taxed at 15% to 20%, there is no additional tax on buybacks.

Stock buyback is a tedious and time-consuming process. It involves restrictions on the issuance of new shares for a specific period, hiring investment bankers, submitting disclosures to stock exchanges, and maintaining a certain debt-to-equity ratio.

Dividend vs share buyback: Which is better?

Dividend is the cash the company returns to all shareholders on specified intervals. It’s up to investors whether they want to reinvest or use it to pay their bills. Long-term investors often choose to reinvest dividends to take advantage of compounding. For others, dividends provide a regular stream of income.

In contrast, stock buybacks are applicable only to a small number of shareholders who surrender their shares at a premium. Investors can choose whether they want to participate in the buyback process. While dividends have no impact on the number of outstanding shares, the buyback reduces the number.

Companies have used dividends as a means to return cash to shareholders for decades. Investors have a fair idea of when and how much dividend they are going to get. It’s hard for companies to stop or reduce dividend payments. On the other hand, buybacks are irregular and can be changed quickly.

Is share buyback a fair game?

Share buybacks are more tax efficient than dividends, which makes them a win-win for the company as well as shareholders. But sometimes the management undertakes buybacks with ulterior motives, which could benefit the promoters and insiders instead of shareholders.

A large part of corporate executives’ compensation is in the form of stock options and awards. The management could use share buybacks to artificially inflate the company’s stock price to their own benefit or the benefit of large institutional investors.

If promoters don’t participate in the buyback, it increases their stake in the company since there are fewer outstanding shares. Companies sometimes take such measures to prevent takeover bids by rivals.

Share buyback is more tax-efficient but a less transparent way to reward shareholders vs dividend payments. Investors need to monitor closely why a company is buying back shares. Many companies such as Apple and Home Depot have used a combination of dividends and share buybacks to reward their shareholders.

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About the Author

Vikas Shukla
Vikas Shukla has a strong interest in business, finance, and technology. He writes regularly on these topics. - He can be contacted by email at [email protected]

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