By Sunil K Parameswaran
A shareholder will usually receive periodic cash payments from a business known as dividends. In America such cash flows are known as cash dividends, to distinguish them from another type of dividends called stock dividends. In India we refer to the latter as bonus shares, and consequently the word ‘dividend’ in India connotes a cash dividend.
Dividends can be volatile
Dividends are not contractually guaranteed and a firm is under no obligation to declare a dividend. No company declares in advance that it will pay x% dividends for the next five years. Thus, in practice dividends can be very volatile. However, good companies try to keep dividends at a steady level, if not at an increasing level, to reassure shareholders that all is well. Finance theory postulates that if a company is unable to invest the retained earnings in projects with a positive net present value, it is better to reward the shareholders in the form of dividends, so that they can explore other avenues for investment.
In western countries, companies offer dividend reinvestment plans or DRIPs. Investors, who enroll in these plans, do not get cash payouts, but receive additional shares equivalent to the declared dividends. This is equivalent to a dividend reinvestment option offered by a mutual fund. Thus, a DRIP offers an avenue for accumulating shares in a company. The advantage is that an investor who needs to liquidate some of the shares, may do so while retaining at least the number of shares he had acquired at the outset.
Stock dividends entail the capitalisation of reserves. That is, funds are transferred from the reserves and surplus account on the balance sheet, to the share capital account. Like a DRIP, this also leads to an increase in the number of shares held by an investor, and permits him to sell shares without having to liquidate a portion of his initial investment.
Stock dividends lead to an increase in the share capital. In theory, they do not have any value, because whether the funds lie in the reserves and surplus account or the share capital account, the ownership is with the shareholder. In the US, companies in some cases issue two categories of share. The first category entitles owners to cash dividends, while the second entitles them to stock dividends. Thus, a shareholder can choose as per his preference.
A share buyback programme is also an alternative for returning capital to the shareholders. A buyback programme, if announced, leads to an increase in demand for the shares, and can arrest the price decline in a falling market. In a share issue, we have a system of book building where bids are arranged in descending order of price. The equivalent, in a buyback programme, is reverse book building, where offers are arranged in ascending order of price. The rationale of book building is that the person who is more eager to buy, and whose aggression is manifested by a higher bid, should be given preference.
In a buyback, a lower offer is a manifestation of greater aggression, and consequently merits priority.
Buyback programmes also permit promoters to increase their proportional shareholding, in the firm, if they are desirous of doing so. This is because if they refrain from offering their shares, their proportional stake will automatically increase.
The writer is CEO, Tarheel Consultancy Services