Buybacks and Dividends are two of the most common ways a Company provides value to its shareholders. Investors often take a decision of investing in a company after looking at the companies history regarding Dividend payments and Stock Buybacks. Investors often argue that a company with a good dividend payout or stock buybacks should be given a better outlook than companies that don’t provide these payments.
But what are buybacks? Buybacks are a corporate action in which a company buys back its own shares from existing shareholders. Usually, buybacks are done at a price higher than the existing stock price. Interested shareholders can tender their shares to the company during its tender period and take advantage of the premium offered by the company.
So what is the difference between Buybacks and Dividends? Dividend is distributed among its shareholders at a fixed date with a certain tax rate according to their tax slab. In Buybacks, the dates of buybacks are not fixed, but investors don’t have to pay any taxes. The company bears the taxes on buybacks.
The company has multiple ways in which it can buyback shares from shareholders. The different methods are listed out below.
Buybacks are a way for the company to give the shareholders the benefit of the excess capital within the company. There are 3 ways through which the company can perform the buyback operation.
- Tender offer
- Through open market – (i) book building (ii) stock market
- from odd lot holders
Tender offer is for shareholders for a certain period of time where shareholders can tender part or all of their shares through the tender. This offer is available to all shareholders. The buyback is offered at a premium than the current stock price. So shareholders will receive a premium for tendering their shares during the tender offer.
Through open market
Through open market, company can use either of the two following ways to perform buyback.
Book Building : This process is where the company will invite shareholders to bid their prices at which they want to sell their shares to the company. Just like an IPO, book is built and the cut off price is decided.
Stock Market: Companies can buy back their shares in the open market by way of block deals/bulk deals over a period of time.
From odd lot holders
Odd Lot holders are investors who have less than 100 shares of the company. The company can decide to buy shares from such investors.
Check also: Basics about the stock market you need to know
How much can the company buyback?
When the company wants to buy back shares, they can only do as much as directed by SEBI rules. SEBI rules state that “The maximum limit of any buy-back shall be twenty-five percent or less of the aggregate of paid-up capital and free reserves of the company“.
Paid-up capital and free reserves are the total cash that is available with the company in that financial year.
Also, the ratio of an aggregate of secured and unsecured debts owed by the company after buy-back shall not be more than twice the paid-up capital and free reserves.
Any company can buyback shares of its own shares only out of the following accounts:
- its free reserves
- the securities premium account
- the proceeds of the issue of any shares or other specified securities.
So the rules laid down by SEBI makes sure that the company doesn’t buy too much of their shares. There are other rules also as to when the buyback should be announced and who is eligible to announce buyback and its process. To know more, click here.
There are several reasons why the company buy-backs its shares. They are as follows:
- To improve the Earning per share. Since the buy-back will reduce the number of shares, the earnings per share will increase.
- To provide additional exit route to existing shareholders when shares are undervalued or thinly traded. Suppose a company is trading at low levels wven when the company is doing well, the company may decide to buyback shares so that the existing shareholders may exit the stock.
- To enhance consolidation of stake in company. This will also increase the stake of the promoters in the copany enhancing their strong presence.
- To prevent any unwelcome takeover bids. Company which buys back its own shares, leaves less shares in the market for others. So any other person who wishes to take a controlling stake can be avoided.
- To return surplus cash to shareholders. To return the value created by the company to its shareholders. This is also a sign of good corporate governance.
- To support share price during sluggish times. To improve the market perception about the stock, promoters may buyback shares to instill confidence in the market about their shares and the compnay prospects.
So while there are many advantages, buybacks are a preferred source of companies to return value to investors.
Dividends vs Buybacks
Dividends and buybacks are both done by the company to increase the shareholder’s value. Both are used by cash-rich companies. Both are signs of healthy corporate governance.
The difference lies in how the tax is levied on these transactions and whether you need to buy or give up your shares to avail the offer.
While if an investors earns dividends, he/she will have to pay taxes as per the tax slab on the entire amount of dividend. While taxes during buybacks are beared upon by the companies and not the investor.
So buybacks are actually a good way for investors to make money without any taxes, but they will have to give up their shares. With dividends, you may pay taxes on income, but you won’t have to give up your shares, and you may continue to receive dividends throughout the time you hold your shares.
So whether dividend is better or buybacks is better depends solely on the views of each investor. Some prefer dividends, which serve as a regular source of income, while other prefer buybacks because of the premium and tax benefits.
So would you tender your shares in a buyback or keep your shares for receiving dividends if the company regularly gives them?.
- Do buybacks happen regularly?
No, Buybacks are not regularly done by the company.
- Is it buy-back or buyback?
The arrangement of the words doesn't change the meaning of the process. They both mean the same.
- Why would a company buyback its own shares?
A company buyback its own shares to increase shareholder value, decrease outstanding shares, company increasing its own stakes, improve investor confidence etc. Many more details are listed above.
- Do i have to sell my shares in buyback?
You will have to sell your shares to the company during the buyback period. Generally, companies pay a premium to the current stock price to take care of this issue.
- What is the benefit of share buyback?
As an investor, you get to sell your shares at a premium price as compared to stock market. For companies, it is a way to sharing company value with investors and many more which is detailed above.