Which is a better choice dividends or buyback of shares?

A company rewards its shareholders for equity Investment in its stock mainly in two ways: Dividends and Buybacks of Shares. For illustration, say a company has earned surplus reserves and has no positive growth projects to invest in, where will the funds flow? Under these scenarios in Equity trading in India, the company prefers paying dividends or purchases their own shares from the investors.

What are the Dividends and Buyback of Shares?

Dividends are the incentives given to the shareholders of the company’s after-tax earnings. They are usually paid regularly on a quarterly basis; however special dividends are also given by several companies. The dividend payment helps in making the company attractive as there are many investors who are drawn towards dividend-paying companies.

However, buyback of shares is a repurchase of its own shares by the issuing company in order to reduce the number of shares outstanding. The main intent behind the process is to increase the price of the remaining stock. The companies undergo the buybacks either by a tender offer or by open market purchase.

So, which is the better choice?

Tax Basis:

Buyback of shares takes a lead when it comes to evaluating on the basis of taxes. In India, the dividends are taxed at 3 levels: first it is an after-tax cash flow given by the companies, second it is taxed again at the company level by a tax called Dividend Distribution Tax and finally it is taxed for the third time in the hands of investor if the amount is more than Rs 10 lakhs in a year in share trading India. Whereas, in the case of buybacks the investors are taxed for long-term capital gains only making it much more economical.

What message does a company send?

Buybacks signify that a stock is undervalued and the company wants to signal the future potential growth opportunities, the share price is expected to increase. Whereas, the dividends provide no such signal.

Valuation Basis:

When companies pay dividends, their stock prices tend to go down and so are the valuation parameters like P/E. However, in the case of buyback of shares, the number of outstanding shares go down and so the valuation parameters like Earnings per shares, cash flows per shares go up. Such improved ratios symbols for an increase in the share prices.

Transparency Basis:

Investors are easily able to gather information about the company’s upcoming dividends payment through many sources, whereas information related to buyback of shares is a little hard to find.

Conclusion

While seeing from an investor’s eyes both the dividends as well as buybacks of shares seems to be lucrative in terms of capital gains. While evaluating comparison, each one has its advantages and disadvantages, however, buyback of shares seem to be winning this race. The buyback of shares are tax-efficient as well as provides signals of a growing company as rightly quoted by Mr. Warren Buffett for the company owners.