Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.
Shareholders invest in publicly traded companies for capital appreciation and income. There are two main ways in which a company returns profits to its shareholders – Cash Dividends and Share Buybacks.
The reasons that drive the strategic decision on dividend vs share buyback differ from company to company and are based on several factors such as the company’s current stock price, its long-term vision, tax structure applicable to the company and its shareholders, the message the company wants to give the stakeholders, investment opportunities, etc.
Before we analyze the decision-making process, let’s review the basics of both these terms:
Dividends are distributed as part of the company’s after-tax profit. Cash-rich companies pay dividends to keep the shareholders’ interest in its stock and it is a common method of returning surplus cash to investors. This is also important for investors looking for regular cash flows, especially those who are dependent on them. Dividends received by shareholders are taxed differently and, hence, become important from a tax planning point of view.
A share buyback is a process in which the company purchases its own shares from its shareholders and, thus, reduces the total number of shares outstanding in the company. The buyback price that is offered to shareholders is generally at a premium to the current market price, which incentivizes them to take part in the process. This process is especially useful when management feels that the company’s share price is undervalued and wants to push the price upward. Buybacks also allow the company to transfer surplus cash sitting idle on the balance sheet to its shareholders.
Companies formulate a strategy on Dividend vs Share Buyback, as it involves certain statutory requirements, restrictions on the issuance of new shares for a certain period, the requirement to maintain a certain debt-to-equity ratio, sources of funding, etc.
Why Cash Dividend?
The cash dividend provides a regular stream of cash for investors. It allows the shareholder to remain invested in the company and still receive regular cash flows. Cash dividend can be a big incentive for investors who rely heavily on their investments to meet their living expenses, especially retired investors who may not have another source of income.
Since the size of a dividend payout is smaller, compared to a buyback, it allows the company to maintain a conservative capitalization structure every quarter rather than just hold large piles of cash.
Buybacks are clearly a more tax-efficient way to return capital to shareholders because the investor doesn’t incur any additional tax on the buyback sale process. Tax is only applicable on the actual sale of shares, whereas dividends attract tax in the range of 15% to 20%. In some countries, dividend payments also attract a Dividend Distribution Tax (DDT), which means for every $1.00 paid to shareholders, the company must pay $1.20 or $1.30 depending on the DDT rate. This process favors the concept of buybacks more than cash dividends.
Advantages of Buybacks
It prevents a decline in the value of a stock by reducing the supply of the stock
With the reduction in outstanding shares, the Earnings Per Share (EPS) of the company improves. This is a good indication of the company’s profitability and may boost its share price in the long run.
The example below shows the impact on EPS if a company buys back 20% of its shares, i.e., reduction of shares from 100,000 to 80,000:
Profit available to shareholders
No. of Shares
Earnings Per Share
It is used as a strategy by management to show its confidence in the company and to send a message that the stock is undervalued. For example, if a stock is trading at $120 and the company announces a buyback at $150, it will instantly create value for its shareholders and price will tend to move upward.
It helps the company use excess cash lying idle from a lack of opportunities. Idle cash earns no additional income for the company. This is true for companies such as Apple that hold excess cash.
If promoters don’t take part in the buyback process, it increases the holdings of the promoters and thus, prevents a potential takeover by rivals. It also provides the management/company with greater control and improves the decision-making process, as there are fewer shares owned by the public. For example, to address issues related to decision-making, Google created two classes of shares, one with voting rights and another without voting rights.
Dividends return cash to all shareholders while a share buyback returns cash to self-selected shareholders only. So when a company pays a dividend, everyone receives cash according to the proportion of their shareholding whether they need cash or not. However, in the case of a share buyback, investors decide whether they want to take part in the process or not. This also gives them the option of changing their shareholding pattern.
A higher EPS would lower the P/E ratio, which is looked at positively in the stock market. Thus, a higher EPS coupled with a lower P/E ratio and higher ROA should have an overall positive impact on the stock price.
The buyback also provides liquidity opportunities for a thinly traded stock.
Disadvantages of Buybacks
It may indicate that the company doesn’t have any profitable opportunities to invest in, which may send a bad signal to long term investors looking for capital appreciation.
It may also give a negative signal about the company’s confidence in itself and promoters may decide to sell their stake.
The buyback process is time-consuming and requires disclosures to stock exchanges and approvals from regulatory bodies. It also involves hiring investment bankers, which becomes an expensive affair for the company.
Accenture, a leading IT company, returns 100% of its annual net income to its shareholders using both ways of returning capital, i.e., a combination of dividend payments and buybacks, with the company preferring buybacks to dividends in a ratio of around 65% to 35% over last 3-4 years. This is a great case of dividend vs share buyback.
Below is the snapshot of the company’s return of cash to its shareholders in the last 5 years:
Amount in USD M
Dividends Paid ($)
Share Buyback ($)
Total Capital Returned ($)
Source: Company Reports
Accenture’s FY16 ROE stands at ~47%, but had the company followed a conservative capital structure or paid dividends rather than doing a buyback, its ROE would have been ~13.4% weighed down by its huge pile of cash.
The Buyback Wins
The above discussion on dividend vs share buyback presents an interesting platform for deciding the optimum capital structure and its impact on stock prices, valuations, etc. However, it seems reasonable to conclude that, notwithstanding a few concerns and exceptional cases, a buyback is a win-win situation for both companies and shareholders.
The buyback process, however, is a bit tedious and expensive as it involves several filings and approvals from stock exchanges. The company and the shareholders stand to gain in equal weight from a buyback offer, making it an attractive option for both of them.
Having discussed the above, it should be kept in mind that buybacks should not be undertaken for any ulterior motive or to send wrong signals and create confusion in the minds of stakeholders in this era of corporate governance.
Applications in Financial Modeling
In financial modeling, it’s important to factor in decisions around paying a dividend vs share buyback. There are various types of models where this decision may apply, including:
In the assumptions section of the model, make an area for quarterly/annual dividends as well as the value of shares to be repurchased. The dividends will flow out of retained earnings but the shares outstanding will remain the same. A buyback will reduce the share capital account and reduce the number of shares outstanding in the model.
Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes.
These courses will give the confidence you need to perform world-class financial analyst work. Start now!
Building confidence in your accounting skills is easy with CFI courses! Enroll now for FREE to start advancing your career!
Take your learning and productivity to the next level with our Premium Templates.
Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI's full course catalog and accredited Certification Programs.
Already have a Self-Study or Full-Immersion membership? Log in
Access Exclusive Templates
Gain unlimited access to more than 250 productivity Templates, CFI's full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.