It is seen that recently few large companies announcing the buyback of shares. Actually, they had huge cash surplus and wanted to return money to their shareholders and do not have other avenues or opportunities for investments. The other way of rewarding shareholders is dividend payout.
Even in public sector companies which are cash rich, usually maharatna’s, government normally requests them to pay out dividends liberally. Apart from regular dividends, these companies declare special dividends and one-time dividend too.
They distribute these to their shareholders when they have a large amount of unexpected gains. Which angle should be considered by you regarding purchasing/selling shares, dividends or buyback of the company?
What does dividend payout indicate?
When a company is making a good amount of money (profit) and is cash rich, it declares a dividend. A dividend is a cash payout by the company to its shareholders.
Taxes and dividends are two things where companies cannot fool around. They are the real thing, where the company has to make payouts.
Must Read: How to recognize a dividend paying company?
Dividend payout is an indicator that company is performing well in commercial terms. And is willing to share its rewards with the shareholders. A higher dividend yield (a dividend expressed as a percentage of a current share price) is a result because of higher dividend payout.
After price to earnings ratio (P/E ratio) and price to book value ratio (P/BV ratio), the dividend yield is the third important factor of valuation of the company.
A stock is considered to be under priced if it shows high dividend yield ratio. It acts as a barrier for the stock falling below certain predetermined level. The dividend is an indicator that the company is performing well, has good cash flow in hand and is on the growth path.
Why company buyback shares?
When a company buys’s its own shares from its shareholders, it is called buyback of shares. It is one of the ways for rewarding its shareholder other than the dividend.
Shareholders, if they want, they can surrender their shares to the company and get their money back, usually with a small upside margin.
Must Read: How to start investing for a useful purpose?
Usually, when companies offer for a buyback, they offer a premium over the market price. That is, suppose the current market value of a certain share is fluctuating between Rs. 1000 to Rs. 1100. Than company offers to buyback it for Rs. 1200. That is an upside margin of Rs. 100 to Rs.200 per share.
When the company buybacks the shares, then those shares will no longer exist. The number of outstanding shares of the company gets reduced this increases earnings per share (EPS).
When the companies buybacks its shares, it is an indication that the company has the confidence that the share value will rise to that price level in future. The buyback price acts as a psychological base for the stock. (Rs.1200 as per our example).
How do dividends versus buyback impact valuations of the company?
Buyback and dividend indicate the company has cash, but not many productive investment opportunities. Both tend to impact the valuation of the company because cash is flowing out of the company.
Usually, investors are more interested in growth rather than a dividend. Because the growth of the company reflects more clearly on valuation. Few companies like D-Mart or Eicher distribute low dividend but are still high on valuation.
Because of the buyback, there is a reduction in shares outstanding which boosts the earnings per share, but it results in downgrading the price per earnings ratio. This impact’s on stock prices in the neutral or negative way.
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