Sunday, July 23, 2006

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.



4 comments:

tejee said...

Ravi

In today's world of creatively written footnotes in annual and quarterly reports, there may be more to the traditional advantages of buybacks than it is apparent. From Dirty Little Secret about Buybacks in BusinessWeek

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Reading Intel Corp.'s (INTC ) latest annual report, you might think the chipmaker has returned huge sums of cash to its shareholders through stock buybacks. Since 1990, the report boasts, the company has repurchased from shareholders "2.2 billion shares at a cost of approximately $42 billion." That's a lot of stock -- about a third of Intel's total shares outstanding. There's just one problem: Intel had as many shares, split-adjusted, at the end of 2004 as it did in 1990.

Much of the cash, it turns out, went to sop up the hundreds of millions of shares Intel was simultaneously issuing for employee stock options. Joseph Osha, a semiconductor stock analyst at Merrill Lynch & Co. (MER ), says perhaps half the cash devoted to stock buybacks in general serves as little more than "backdoor compensation" for employees
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Ravi Purohit said...

Tejee: Thanks for pointing me to this article. It says a lot more about the buy-backs than I knew. However, ESOPs are still not as big in India. Not many companies are doling out ESOPs at frantic pace as seen in the US.

However, what is still difficult to understand is that how does a dividend increase shareholder wealth? Dont share prices adjust by a corresponding amount on the bourses....so where is the addn wealth coming from?

Prasanth said...

Ravi,
In the case of dividends, you should should not just conider short time fall of the share value. In the longer term, if the company is good, then the value of the share will increase and short term fluctuations do not matter. You only have to look at the track record of good companies who have been conistently paying out dividends.

I prefer a good dividend to a share buy back !!

Prasanth

Ravi Purohit said...

Prasanth,

Consider a case where a company earns a ROCE of 20+% would you want that company to payout dividends or rather invest the same into the business to grow it further. Dividends dont make sense since they neither give u capital appreciation nor help add to your wealth? What I am tryin to home down at is that a good company will be much better off re-investing the money it generates year after year.

-
Ravi