Stock buybacks vs dividends: two ways companies return cash
Companies return profits to shareholders through dividends or share repurchases. Here is how each works, how they are taxed, what rules apply and what to watch in an earnings release.
When a company earns more cash than it needs to run and grow the business, it has a few choices. It can keep the cash, pay down debt, buy another company, or return it to shareholders. The two main ways to return it are dividends and stock buybacks, also called share repurchases. They can end up delivering similar value, but they work differently and send different signals.
How a dividend works
A dividend is a cash payment to every shareholder, usually stated as an amount per share. A company paying a quarterly dividend of 50 cents a share sends $50 to an investor who holds 100 shares. The board of directors declares each dividend and sets several dates: the declaration date, the record date, which determines who is entitled to be paid, and the payment date. Stock exchanges set an ex-dividend date shortly before the record date, and buyers on or after it do not receive that payment.
Companies tend to treat regular dividends as a commitment. Cutting one is often read by investors as a sign of trouble, so boards usually set a dividend they expect to sustain through bad years. Some companies also pay occasional special dividends when they have an unusual amount of excess cash.
How a buyback works
In a buyback, the company uses cash to purchase its own shares, most often in the open market over months or years, though it can also use a tender offer or an accelerated arrangement with a bank. The repurchased shares are typically held as treasury stock or retired. Either way, fewer shares remain outstanding, so each remaining share represents a slightly larger slice of the company's earnings.
Shareholders who do not sell receive no cash, but their ownership stake grows. Those who want cash can sell some shares themselves. A board will usually authorize a repurchase program up to a dollar amount, but an authorization is not an obligation, and companies can slow or stop purchases without the stigma of a dividend cut. That flexibility is a large part of buybacks' appeal.
The rules
For decades, companies were reluctant to buy back shares in large amounts because of concerns about market manipulation claims. In 1982 the Securities and Exchange Commission adopted Rule 10b-18, which provides a safe harbor from manipulation liability if a company's purchases meet conditions on timing, price, volume and the broker used. The rule does not require companies to follow those conditions, but most large repurchase programs are designed around them. Buybacks grew substantially in the decades that followed.
The Inflation Reduction Act of 2022 added a 1% excise tax on the fair market value of stock repurchased by publicly traded US corporations, generally net of new stock issued during the year, effective for repurchases after December 31, 2022.
Companies disclose repurchase activity in their quarterly and annual reports filed with the SEC, including a table of shares bought each month and the average price paid.
Taxes for shareholders
Dividends are taxable income for shareholders in taxable accounts in the year they are paid. Qualified dividends, which generally covers dividends from US companies and certain foreign companies on shares held for a minimum period, are taxed at the lower long-term capital gains rates rather than ordinary income rates. A buyback creates no tax for a shareholder who does not sell. Shareholders who sell pay capital gains tax only on their gain, and only when they choose to sell. That ability to defer tax is one argument for buybacks over dividends, though it does not matter for shares held in tax-advantaged retirement accounts.
Arguments for and against buybacks
Supporters say buybacks are an efficient way to return cash that the company cannot invest at good returns, that they let shareholders control the timing of taxes, and that they give management flexibility.
Critics raise several concerns. Companies have sometimes bought back shares heavily when prices were high and stopped when prices were low, the opposite of good investing. Buybacks raise earnings per share by shrinking the share count, which can flatter a performance metric used in executive pay even if total earnings are flat. Some buybacks mainly offset new shares issued to employees as stock compensation, so the share count barely falls. And critics argue that money spent on repurchases could instead go to wages, research or investment, though supporters respond that the cash flows back to investors who can deploy it elsewhere in the economy.
What to look for in an earnings release
- Net share count. Compare diluted shares outstanding from one year to the next. If a company spent billions on buybacks but the share count stayed flat, the repurchases mostly offset stock compensation.
- Funding source. Check the cash flow statement. Buybacks funded by free cash flow are different from buybacks funded by new borrowing.
- Payout ratio. The share of earnings paid out as dividends shows how much cushion the company has if profits fall.
- Price paid. The average repurchase price in quarterly filings shows whether the company bought shares cheaply or expensively relative to where they trade later.
- EPS versus net income. If earnings per share grew faster than net income, the gap came from a lower share count, not from a larger business.
The bottom line
Dividends and buybacks are two routes to the same destination: returning cash to owners. Dividends are steadier and more visible. Buybacks are more flexible and more tax-efficient for some investors, but they are easier to use in ways that make results look better than they are. Reading the share count and the cash flow statement tells you which kind you are looking at.
This article is general information, not investment or tax advice.