Dividends and Buy backs

EXCESS CASH


There are always corporates which work hard to bring in more wealth for their employees and shareholders. However, how is the cash that has been produced be transferred to its real owners - the shareholders? There are a few direct and indirect ways by which this can be achieved. We are going to look at 2 of the ways here.


DIVIDENDS


Dividends are the first and direct way by which excess cash reaches the shareholders. Giving dividends is always a safe way to keep the stock at a higher price. For example, assume that a company AAA gives a generous dividend or Rs.1 per share which is trading at Rs.25. It means, the investor gets 4% money as return via dividends itself. Now, can the stock price fall below to Rs.10 or below? Thought it might be possible, in a general market it wont. Because in this case you are getting 10% money on the investment made which is more than the bank fixed deposits. So, the fact that the company gives dividend itself keeps the stock price higher.

Companies which are in their high growth path do not prefer paying dividends for known obvious reasons. In stead of paying out cash, they can use it more efficiently. Also this is the preferred approach than borrowing money at high interest rate and getting yourself burnt during the hard days.

As a precautionary note, when one selects a stock only on the dividend basis, one should also verify that the company has a long history of giving generous dividends. Moreover, quality of dividend should also be verified. i.e. if a company earns Rs.5 a share and distributes Rs.1 to the shareholders, then even when profits go down by 30% to 40%, the company won't be under pressure in continuing its dividends. But its not the case where the company earns only Rs.2 per share.


BUY BACKS


Though giving higher dividends is very profitable for investors, it has a hidden trap. Investors are taxed twice while getting dividends. Any company that makes profits need to pay taxes to the government. Continuing our previous example, if our company AAA makes Rs.5 a share, it has to pay taxes say Rs.1.50 (or 30%) per share. So the company has only Rs.3.50 as profits after it has paid its taxes. Now if it decides to give Rs.1 per share dividend, there comes the catch. The share holders are taxed on the dividend amount they get (deducted at the source itself). So, in stead of shareholders getting Rs.1 they will get only Rs.0.80 (assuming 20% tax) thus taxing the shareholder the second time. So companies these days are not preferring to pay dividends thus protecting the shareholders from double taxation. In stead they transfer money indirectly by buying back their shares from the market and thereby increasing their ownership in the company. As a result, share prices climb up and if the shareholder has owned the share for above one year, it doesn't come under revenue but under capital gain which is taxed at a lesser rate. The problem with buy back is that it causes your capital to increase and you wont enjoy its benefit till you sell the share to someone else.