There are two main ways companies can return spare cash to shareholders, dividends and share buybacks.
Dividends have been a regular part of investing for decades. But in recent years, the popularity of buybacks has skyrocketed.
But what’s the difference? And more importantly, what do they mean for you as an investor?
This article isn’t personal advice. If you’re not sure if an investment is right for you, seek advice. Investments and any income they give you can fall as well as rise in value, so you could get back less than you invest.
What are they?
Dividends are cash payments to shareholders.
‘Ordinary’ dividends are usually paid twice a year, after interim and final results, for example. This means that if you hold shares in a company with a track record of paying dividends, you could get a steady source of income. But keep in mind that dividends are at the boards’ discretion, and final dividends typically rely on shareholder approval, so they’re not guaranteed and can vary.
How does it affect investors?
If you’re looking to use dividend payments as an income, you’ll want to look at a company’s dividend yield. That’s the annual dividend payment as a percentage of its current share price.
So, if a company’s share price is 100p and it paid dividends of 6p over the last year, its dividend yield is 6%.
But because yields are usually calculated using last year’s dividend, it means they aren’t a reliable guide to the income you’ll get in the future.
For example, a company’s share price might halve during a troubled time, causing its historic yield to double. That higher yield might look attractive on paper, but if the shares have fallen because profits are lower, then dividends could be lower in the future as well.
We prefer to use forward dividend yields, which are based on estimates of dividends over the next 12 months – this often gives a better reflection of expected income.
Forward yields can be tricky to find, but we provide this and more for the stocks on our coverage list.
What does it mean?
Dividends tell us a few things about a company.
If a company announces it’s about to start paying dividends, the message is it’s making enough cash that it can give some back directly to shareholders.
Companies rarely start making payments without being confident they can continue to pay the dividend over a long time period.
But if a company has historically reinvested for growth, then decides to pay a dividend instead, investors could question whether those potentially profitable growth opportunities have dried up.
The message when companies cut the dividend is usually clearer – it’s a bad sign. Cutting a dividend that’s been steadily increasing usually causes the share price to fall. It also tends to have a bad impact on how investors now view the company.
Take Coca-Cola for example. It’s paid a quarterly dividend since 1920, and has increased its dividends each year for more than 60 years. If it were to suddenly cut the dividend, it’s unlikely to give investors a positive message.
Of course, there are no guarantees that this will continue, and past performance shouldn’t be seen as a guide to the future.
As an investor, receiving dividends gives you the flexibility to choose what you do with the cash. You could:
- Reinvest to buy more shares in the company
- Buy shares in another company
- Use it as an income stream
You can be taxed on dividends when you hold shares outside an ISA and a SIPP. So, receiving a higher payment and then reinvesting it back into the company might not be in your best interests. Tax rules can change, and benefits depend on your individual circumstances.
Your 2023 tax guide – what you need to know
If you reinvest your dividend payments back into the company, a share buyback is basically a shortcut to the same result.
What are they?
A share buyback is when a company uses its excess cash to buy its own shares, which typically reduces the number of shares outstanding.
How does it affect investors?
When companies buy back their own shares, you’ll own the same number of shares as before. But because there are now fewer shares in existence, it can push up the value of your shares. You’ll basically have a bigger slice of the same pie.
Warren Buffett, when talking about Apple, explained it like this:
“When I buy Apple, I know that Apple is going to repurchase a lot of shares. We own about 5%. But I know I don’t have to do a thing and probably in a couple of years we’ll own 6% without laying out another dollar. Well, I love the idea of having 5% go to 6%.”
What does it mean?
Ideally, share buybacks will take place when the company’s management thinks its shares are undervalued. This is one half of the basic ‘buy low, sell high’ mantra.
These executives are arguably best placed to know the value of their company’s own shares. Buying back shares when they’re selling for less than their true value is like buying a pound for 90 pence. Of course, identifying the true value is never easy, but in theory it’s a great way to add value to the company. And when that happens, it’s shareholders that reap the benefits.
Well-executed share buybacks can also save shareholders having to pick the right time to reinvest dividend payments. But there’s always a danger management could buy back shares at the wrong time.
It’s also important that buybacks are not made just to prop up stock prices or boost metrics which are linked to management’s bonuses. Buybacks should only be made because they offer attractive returns as investments in their own right.
Generally, share buybacks can:
- Give a positive signal that the company thinks its shares are worth more than they’re trading at – but remember this won’t always be the case.
- Increase the value of existing shares.
- Cut out the middleman. If you reinvest your dividends, a share buyback does it for you, saving you dealing charges.
Which one is better?
There’s no clear winner in the buybacks vs dividends debate, both are usually good news for investors. But it’s important to remember their differences.
The key point is that dividends are better for income, while buybacks are more geared towards capital growth.
A company is under no obligation as far as share buybacks go. In most cases, it can start and stop repurchasing shares whenever it wants. They aren’t committed to dividend payments, either, but management will typically think about stopping a buyback before cutting the dividend.
Whatever your circumstances, understanding the differences means you can choose what’s right for your investment goals.
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