Companies must focus on providing investors with financial returns on their investments. After all, investors often put their money in a company for the purposes of capital appreciation and income. The most commonly known way to provide a return on income is through stock dividends. But that is not the only way.

Companies return surplus cash to investors and add value for shareholders through dividends and also through share repurchases. While these cash distribution methods differ in approach, they can both increase returns for investors and raise the company’s overall valuation.

Several factors drive the decision to return excess profits to shareholders in the form of dividends or share buybacks. These factors include the company’s stock price, tax considerations, and how outsiders will perceive the decision.

Distributions of Dividends

Dividend payments result in cash returned to shareholders in proportion to their ownership stake in the company. When a company has excess cash on its balance sheet, it often sets aside a portion for dividend payments to investors. This helps maintain shareholder interest in the company.

Some companies pay dividends at regular intervals to entice investors with regular cash flows. Often dividends are paid quarterly. Examples of companies that have historically paid quarterly dividends to shareholders include Chevron, Target, AT&T, and Gilead Sciences. The board of directors decides whether to pay out dividends, as well as any increases or decreases in the dividend amount from the prior period.

Companies pay out dividends from their after-tax profits. When shareholders receive the dividends, they are taxed at a lower tax rate than ordinary income. Hence, from a tax savings perspective, it is advantageous for investors to receive dividend income.

Cash dividends are more common than stock dividends. With cash dividends, the company is depleting the cash reserves of the company in order to pay out investors rather than reinvesting that cash into the business. In contrast, with stock dividends, a company does not touch its cash reserves or profits. Stock dividends occur when the company issues additional stock to its shareholders. Stock dividends are generally more advantageous to investors because they are usually not subject to tax. However, many investors enjoy the consistent and steady source of income cash dividends provide.

Share Repurchases

Share repurchases, also commonly called share buybacks, are an alternative to distribution of dividends. Stock repurchases take place when a company repurchases some outstanding shares it originally issued. This reduces the total number of the company’s outstanding available shares and prevents a decline in the stock price. A company’s leadership team will sometimes strategically implement a share buyback program to push up the company’s share price.

Unlike stock dividends, reducing the total number of outstanding shares can also increase the company’s earnings per share (EPS). The EPS is a common gauge of a company’s profitability. An increase in the EPS may boost investor confidence in the long-term performance of the company’s stock.

Share buybacks are an alternative way to return surplus cash to investors, as opposed to dividends. Investors do not incur taxes on the buyback sale process itself. Taxes are only paid when investors sell those shares. Thus, compared with dividend distributions, share repurchases can be a more tax-efficient way to return capital to shareholders.

How Buybacks Work

When a share buyback is announced, the price offered to existing shareholders is usually above the stock’s current market value. In the case of a share buyback, investors can decide whether to participate in the share buyback. This contrasts with dividend distributions, which return cash to all investors.

A number of large technology companies have recently announced share buyback programs. In September 2021, Microsoft’s board of directors approved a record $60 billion stock repurchase program. Microsoft held $40 billion share buyback programs in 2013 and 2016, respectively. Apple, Alphabet, and Facebook have also spent billions on share buybacks.

While share buybacks have many advantages to companies and investors alike, the buyback process is tedious. The company must provide extensive disclosures to the Securities and Exchange Commission (SEC) and to the stock exchange it’s listed on. The process also involves expensive fees paid to investment banks.

Takeaways: Dividends or Repurchases?

While many companies find dividends and share repurchase programs to be effective ways to return excess cash to investors, early-stage startups should proceed with caution. If the business is growing rapidly, it is often more beneficial for the company to reinvest excess cash into growing the business. In conclusion, a startup should evaluate the benefits and drawbacks of dividend payments and share buybacks to determine whether it makes sense to return surplus cash to investors.