There are two main ways companies share profits with shareholders.

The direct way is to pay a dividend.

U.S. dividend-paying companies typically declare and pay a dividend every quarter. Every three months, cash comes into your investment account.

Some companies even pay every month.

Helping Shareholders Another Way

Another way companies reward shareholders is through share repurchases—buying its own stock on the open market. They could also make a tender offer to existing shareholders.

Once repurchased, the shares are retired/canceled. These shares no longer constitute ownership stake in the company and have no value.

The company’s buying action not only creates support for the stock price on the market, through the reduction of the number of outstanding shares, the remaining shares held by other shareholders end up with a larger proportion of the company’s equity.

To illustrate, consider a hypothetical company that generated $500 million in profit. It has 500 million outstanding shares. The EPS (earnings per share) is thus $1. But if it rebuys 10 million shares, the EPS is now $1.02. As a shareholder, you didn’t do anything but the EPS automatically went up by 2%. It all happened behind the scenes.

In fact, sometimes if a company buys back enough shares, it could mask a decline in net income because EPS could still increase. As usual, it would make sense to do your due diligence and look at some financial statements before investing.

Another way to look at this is that, all else equal, a company’s P/E (price-to-earnings) ratio would fall when the number of outstanding shares goes down. This would make the stock look more attractive to potential investors on a valuation basis. If this leads to additional buying interest, it, too, would benefit existing shareholders.

Buybacks vs. Dividends

Dividend paid by stocks held in taxable accounts are taxable even if you choose to automatically reinvest the dividend. On the other hand, the benefits you enjoy from company’s share repurchases are not taxable (until you realize any gains through selling).

Also, once the board of directors authorizes a share repurchase plan, management has discretion when exactly it pulls the trigger and how much to buy. Thus, it can try to optimize the timing—such as buying more shares when it thinks the stock is undervalued. In contrast, for U.S. companies, management typically has to stick to a regular dividend distribution schedule.

Still, many investors prefer receiving the dividend because you get the cash in hand. You can reinvest it into the same stock so you have more shares, you could invest it in another stock, or you could just invest it less risky things like CDs and money market funds.

On the other hand, in the case of repurchases, even if a stock you own goes up due to the company’s actions, those gains could evaporate because the stock could still fall later on. It’s the classic “a bird in the hand is worth two in the bush” situation.

Note that when a company reduces the number of outstanding shares, and it pays the same dollar amount in dividend per share, it actually saves money on the total dividend it has to pay out in the future.

And if the company decides to pay out the same total amount, then each shareholder would receive a higher dividend per share.

Sign of Good Financial Health

In any case, if a company is able to execute a generous share repurchase program, it’s usually an indication that the company is in good financial shape. After all, a company that isn’t generating ample cash flow should not even consider buying back shares.

Provided the company isn’t foregoing better use of the cash—such as by investing in attractive projects that would create more value for shareholders—a share repurchase program is a positive for investors.

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