What do companies do with their profits?
For many companies, the question as to what one should do with profits is a tricky one. There is always re-investing that money back into the company (which is not always necessary), stock buybacks and dividend increases. The choice is largely up to the company and its Board of Directors and many investors sometimes chase companies based on the above characteristics.
Dividends and Buybacks will almost always boost shareholder value but it may be to the detriment of corporate profits. The golden rule for companies when deciding which option to go with is generally based on the company’s opportunity cost. That is, is there a place where the company can be earning more. At the end of the day, management’s ultimate responsibility is driving shareholder value and they will pick the option which is better. Take a company like Amazon that does not pay dividends. The reason being that Amazon can earn a substantially higher return if they re-invest funds. Usually growth companies refrain from paying dividends as the capital appreciation if reinvested is far greater.
Why investors love buybacks:
Buybacks usually lead to improved shareholder value. In recent years, Apple has deployed this strategy to perfection, embarking on several buybacks to help boost its stock price. The reason why buybacks help boost shareholder value is due to the boost in Earnings Per Share (EPS). Earnings per share is essentially the net profit the company generates / the outstanding shares on the market.
If a company does a buyback, the shares reduce boosting the EPS (if profitability remains the same). For investors that hold onto shares, each share now represents a higher ownership percentage (more take on the earnings) and a higher price per share. The best time for companies to do buybacks is when the stock is undervalued. This will allow the company to get the best bang for their buck while inflating the share price during times of depressed stock prices. However, as an investor keep an eye out as to when companies do buybacks, as sometimes can use buybacks to boost share prices when financial performance is not optimal.
Dividend Increases are quite simple - as this just indicates that each investor will receive a higher dividend per share. Dividend increases are common among larger companies in which capital reinvestment will not yield significant results.
Why do some companies avoid paying dividends?
If a company believes it can obtain a better capital return from reinvesting profits it will not pay a dividend. There is a lot of “pressure” when it comes to issuing dividends. Shareholders come to expect a steady stream of income and always “expect” dividend increases. If a company also needs to reduce their payout, this can reflect negatively on the price of a stock.
A final word on taxes: Different countries will treat capital gains and dividends differently - so each outcome that a company chooses may be different for each individual investor. Buybacks will usually result in Capital Gains (unrealized).
Disclaimer: All of the above information is my own personal opinion. Examples listed above are for educational purposes only. Please consult with a licensed representative before making any financial decisions and please do your research.