When a company generates a profit, cash accumulates on the balance sheet. The company will then have a few options on what it wishes to do with the cash. It could hold on to it as reserves or perhaps even reinvest it into the business in hopes of generating growth. If a company does not believe that it can make a good return from investing cash, then it will likely return the cash to shareholders by issuing or buying back shares.
A dividend is a payment from profits directly to shareholders in proportion to their shares. Meanwhile, a buyback is where the company uses the cash to repurchase its own shares on the stock exchange. Companies usually choose to pay dividends rather than buy back shares, unless management considers the shares to be undervalued. In this case, they will view a repurchase of shares as more beneficial due to a greater chance of them increasing in value in the near future.
When a company buys back a share, the share is basically deleted, which increases the portion of company ownership represented by each other individual share. The benefit of this to shareholders is that by decreasing the outstanding share amount, existing shareholders are given increased ownership of the company, including their shares of future profits. In short, if a company feels like it has a good opportunity to grow, it should reinvest the capital. If it believes that its shares are undervalued, then it should repurchase them from the stock market. Otherwise, it's far easier and better for shareholders that a dividend is issued.
Key Takeaways:
1. Companies can choose to hold onto cash reserves, reinvest them into the business, or return it to shareholders by issuing a dividend or buying back shares.
2. A dividend is a payment from profits directly to shareholders in proportion to their shares, while a buyback is where the company uses the cash to repurchase its own shares on the stock exchange.
3. If a company believes its shares are undervalued, it should repurchase them from the stock market.
