A business that is doing well will often have what is known as retained earnings – the portion of net income it keeps in a separate account. This can be used in a variety of ways, such as funding expansion or major capital projects. However, retained earnings can also be used to pay dividends or to repurchase its shares in the open market.
Share repurchases (or buybacks) and dividends are a means by which publicly traded companies can return cash to their shareholders. A company can fund its buyback by taking on debt, with cash on hand, or with its cash flow from operations. A set of corporate principles, known as a ‘pay-out policy’, will typically guide the value of any proposed cash dividends and share buybacks.
In practice, a buyback will see the company buy its own shares from the open marketplace, effectively cancelling these to reduce the number of freely trading shares (or ‘share float’) in the market (hence a buyback is sometimes referred to as a ‘float shrink’). The company can also make a tender offer, where existing company shareholders are asked if they wish to tender some or all of their shareholdings within a certain time frame; the offer includes the number of shares the company wishes to acquire and its offer price range.
Conversely, dividends are offered as a share in the company’s profits on a discretionary basis. These are paid out or ‘distributed’ at regular intervals to shareholders, mostly as cash but sometimes as shares of stock or other benefits. Dividends are declared (authorised) by the board of directors. Their value or distribution may be constrained by debt covenants.
Of the two, buybacks are usually seen as the more tax efficient, if less direct, way to return capital to shareholders. Whereas dividends are a definite taxable return and are subject to different tax treatments at both the corporate and personal levels, buybacks have uncertain value and tax is deferred until the investor sells.
Returns on share buybacks can never be guaranteed, but with corporate cash pools increasing, they appeared to be on the rise, especially in the US. In 2018, US companies saw a peak buyback of US$866bn, Apple alone undertaking US$100bn in buybacks during that year.
However, according to the FT in February 2020, citing preliminary figures from S&P Dow Jones Indices, US corporates bought back US$736bn of their own stock in 2019. This was down 19% on 2018. On the other hand, a record-breaking US$485.5bn was paid out in dividends, with 2019 now the second year in a row that more than US$1trn was returned to shareholders.
Dividends are a share of company profits, paid at regular intervals to its shareholders. Its directors are free to distribute dividends at whatever value they see fit, on the proviso that they are derived only from company net profits.
Not every company pays dividends. Rarely will a start-up or high-growth company offer a pay-out. These businesses often report losses in their first few years. If there are profits, these will often be ploughed back into the business.
Dividends are usually associated where a mature business has notable positive (and predictable) income streams and profits. These companies may not exhibit the huge growth curves of their formative years, but as established market players, dividends (usually paid at a higher rate than more dynamic/less predictable businesses) can boost overall returns for those that have invested in the company’s stock.
Cash is the most common pay-out but some companies issue shares of stock as an alternative. According to Standard & Poor’s, since 1932, cash dividends have made up about one-third of the total returns on US stocks, with the remainder coming from price appreciation, or capital gains, on that stock.
Dividends have two main roles: to signal to investors that the company is healthy and has a future, and to attract investors by paying them a regular income, possibly increasing the market value of the company’s stock.
There are several reasons why a business may choose not to pay dividends. If rapid growth is part of its strategy, then earnings can be invested back into the company. That business may also wish to use its cash to fund M&A activity. Conversely, a business that is perhaps not so strong may choose not to pay dividends simply to avoid the negative impression it gives to the market should it ever need to stop paying or lower its pay-out.
Types of dividend
Although cash tends to be the preferred form, dividends may take several forms. The list includes:
As the most common form, cash dividends issued per share are simply a cash payment whose value has been calculated by using the dividend per share (DPS) formula shown below.
Other forms may be known as distributions-in-kind. These may be used as a means of reducing corporate tax liabilities that may arise from, for example, an increase in an asset’s value.
As an alternative to cash, a number of shares may be awarded to each shareholder based on the amount of shares they hold. This may be done on a pro-rata rights basis. This is not obligatory in terms of offer or uptake but the idea is to ensure that extra share issuance does not dilute the existing ownership or voting rights of the shareholder, maintaining their percentage of equity stake at the same level.
Dividends may be offered as an asset such as property, plant, and equipment (PP&E), which is generally highly illiquid, or inventory, which is more liquid.
Sometimes a company will offer its shareholders a choice of either receiving a cash dividend or the equivalent in additional shares of the company. Scrip issues are usually offered when there is insufficient liquidity for a cash dividend to be paid. By increasing the number of shares, these secondary issues will dilute share value but they are exempt from stamp duty as they are not an investment per se – even though investors can sell them on the open market (at which point they are subject to capital gains).
This is an end-of-the road dividend where all assets are liquidated and the remaining proceeds (if there are any) after satisfying creditors are paid out to shareholders as a dividend. Creditors are always senior to shareholders in such a case. A liquidating distribution usually only occurs where a solvent business is in voluntary liquidation.
The main calculation used to decide the value attributed to each individual share in a dividend pay-out is DPS. DPS determines total income for each investor, based on share ownership.