What increases shareholder value - dividends or buybacks?

Lets take the first case: Dividends

Dividends are profits earned by a company and shared with its shareholders. So if a company earns let say Rs.100 crore in the current year and has retained profits of earlier years amounting to another Rs.500 crore, it technically has Rs.600 crore which belongs to the shareowners and can therefore be shared with them by way of dividend payouts. Economists, financial consultants and ofcourse companies across-the-globe have long argued that dividends are a way of rewarding shareholders or put simply sharing some of the profits that the company has earned.

However, do dividends really add to your wealth? I think not.

Reason: Share prices on the bourses quickly adjust (read: decline/fall) by the same quantum almost immediately. That means, if I owned a share worth Rs.100 & which paid a dividend of Rs.10 per share, the stock will immediately fall by Rs.10 on the bourses on the ex-date. So where is the reward/gain....?

Next is buybacks: Companies announce buybacks when they have ample cash (more than what is required to run & expand the business) in their books and instead of paying direct cash to the shareholder they offer to buy shares from the market at a price which is higher than the prevailing market price (that is obvious actually). Microsoft recently announced one.

So how does a buyback benefit a shareholder?

The answer is: It does not to the shareholder who sells out to the company, but benefits the one who does not. The reason is quite simple, shares bought back under a 'buy-back' scheme are cancelled thereby reducing the total shares outstanding. Reduction in shares results in an increase in the earning per share, which pulls down the price-to-earning ratio. If the company is well-run then a lower p/e ratio will attract new investors, driving up the share price.

However, buy-backs increase shareholders wealth only when done in the form of a 'tender-offer'. In recent times there have been cases where companies have announced buy-backs but not in the form of tender offers but by offering to buy shares from the secondary market at a price they feel right. Put simply, the management has no obligation to buy its share back under this form of buy-back and guess what more often than not it actually ends up buying no share, eg. Reliance Industries (in 2002-03), SRF Polymers and SRF Ltd (more recently).....etc.

Bottomline: Dividends do not add shareholder value, not anymore. Tender-offers do, but plain buy-backs do not.