Investors invest in the share market for financial rewards. A publicly listed company has two main ways to return the profits gained by the company – cash dividends and stock repurchases (share buybacks). Cash dividends are distributed to the shareholders after the company’s after-tax profit. Cash dividends are an attractive source of consistent income, especially for retired investors. While share buyback means repurchasing its shares by a company from its shareholders, thus reducing the total number of shares outstanding in the company which increases the value of the company’s shares.
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Why Cash Dividends?
Cash dividends are the most common way to distribute capital gains to investors. Cash dividends keep investors interested in regular income. Well-established companies with stable cash flow are more suited to provide cash dividends. Growth companies need cash for expansion. So, growth companies keep the profits to expand their services and may not pay dividends. In the context of NEPSE, companies like NTC (Nepal Doorsanchar Company Ltd), UNL (Unilever Nepal Limited), BNT (Bottlers Nepal (Terai) Limited ), etc. have a history for handsome cash dividends.
#Advantages and Disadvantages of Cash Dividends
Stock prices may move up and down over time but the cash dividends received are not going anywhere. Cash dividends mean cash in hand which can be used to make alternative investments or can be used for other needs. The company distributing cash dividends will not need to worry about the investment.
After distributing cash dividends the company will not have liquidity for the growth of the company. Similarly, the shareholders are entitled to high taxes for receiving the cash dividends.
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Why Share Repurchases?
A company may buy back its shares for the company’s consolidation or increase its equity value. The main advantage to shareholders that share buybacks provide is tax-free financial returns. Share repurchasing is the most tax-efficient way to repay the investors as the shareholders don’t need to incur any tax in this process. Taxes are only levied when the shareholders sell the shares. In most countries, tax is a headache for investors as dividends attract tax in the range of 10% to 20%. Share repurchases generally enhance the financial and profitability indicators of the company, like earnings per share (EPS), price–to–earnings ratio (PE), net worth per share, cash flow per share, and return on equity (ROE). This eventually leads to the increase in the price of the share in the capital market attracting other investors.
#Advantages of Share Buybacks
1. Stronger financial statements:
The reduced number of outstanding shares due to stock repurchasing will automatically increase the earnings per share (EPS) ratio. This eventually lowers the price to earnings (PE) ratio. These positive financial changes are very appealing for investors. For example, a company, say ABC, which has an EPS of 10 rupees traded at Rs. 200 with a PE ratio of 20, has an annual income of 10 million rupees with 100,000 outstanding. If the company buybacks its 10,000 shares. The EPS of the stock will increase to Rs. 11.11 while the PE ratio decreases to RS. 18 at the same traded price (Rs. 200) but the outstanding shares will only be 90,000. ROE (return on equity) also gains a boost.
Stock repurchasing ensures the strong financial health of the company which provides the investors to invest with confidence in the stock. The age of technology aiding to fundamental and technical analysis makes these changes easy to pick by the analysts and eventually the surge in high stock price with heavy buying pressure.
2. Positive signal for investors:
Whenever a company announces share repurchase, it gives a positive signal about the company’s future growth. Stock buybacks are interpreted as the management’s confident company’s financial health and that the company is potentially undervalued. This will immediately move the price of the stock in the upward direction.
3. Avoids poor investment decisions:
Utilizing the excess cash is an important aspect to keep the investors interested in the company. Making a good investment decision for satisfactory gains can be challenging. Poor investment decisions by the company can deprive the shareholders of potential dividends. Thus, share buybacks can be an excellent way to utilize liquidity without taking much risk. It is a very effective strategy for well-established companies which can save a lot of headaches for making investment decisions.
#Disadvantages of share buybacks
1. Missing out on investment opportunities:
Investment should be made to earn the higher possible returns. A young and growing company must utilize the available cash to boost its returns. Stock buybacks mean the company is unable to make better investment plans. This could affect the future earnings of the company and the returns may be stagnant in the future.
2. Risks with debt:
Many companies might take additional debt to generate the capital required for share buybacks. The companies levered with debt in most of the cases. Financing share buybacks with further debt is a recipe for disaster for young companies. If the company is not able to pay off the debt, it can run into some serious financial problems.
3. Bad signal for long term investors:
Share buyback suggests the lack of opportunities for expansion and growth of the company. Lack of profitable opportunities may give negative vibes to the long-term investors.
4. Company’s overvaluation:
If a company buybacks the shares at high prices, the shareholders will have the burden of further overvalued shares. Timing is essential in share buybacks, and untimely repurchases at an overvalued price can do no good to the company’s shareholder’s equity. In this case, selling the shares would make more sense than buying more or holding the shares.
Conclusion: Which is Better for Investors?
Barring some exceptions, stock repurchasing has been proved more profitable for both company and the shareholders. Buybacks certainly produce higher capital gains in the long run than those obtained from cash dividends. Since investors don’t need to pay taxes until they sell the shares, stock buybacks being tax-effective saves a lot of headaches.
Similarly, the investors don’t need to worry about making investment decisions from the cash dividends obtained. Thus, in a financially sound company without debt share buyback is seen as a prized opportunity for long-term investors.
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