From the time the dividends above Rs.1 million a year where made taxable, there has been a clear shift in favour of buybacks over dividends. That is hardly surprising. In the last few months we have seen some large companies like TCS, Wipro and HCL Tech announcing massive buyback programs. Most of these companies are sitting on billions of dollars in cash and need to return the money to shareholders if they do not have alternative investment opportunities. Remember, buyback is only one way of rewarding the shareholders. Another popular way of rewarding shareholders is through dividend payouts. In fact, the government normally requests its cash-rich PSU companies to pay out liberal dividends. Apart from higher regular dividends, these companies also declare special dividends and one-time dividends to distribute any windfall profits to their shareholders…

Let us first understand, what a dividend is 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.

Now let us shift to what exactly is a buyback of shares and why it is done?

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.

Remember, there are major differences in the tax treatment of both

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.

Let us look at the impact of dividends and buybacks on the 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 would be interesting to see the experience globally. It is found that during normally markets, the dividend stocks and the buyback stocks tend to marginally outperform the benchmark indices. 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. That could be the key take-away from this debate!