Questions You Were Afraid to Ask #17: What are dividends, stock buybacks, and stock splits?

The only bad question is the one left unasked. That’s the premise behind this series of articles. Each covers a different investment-related question that many people have but are afraid to ask.

In recent articles, I’ve been breaking down some of the more common bits of financial jargon that you are likely to hear in the media about the stock market.  In this message, let’s look at three terms regarding how companies can return value or otherwise impact their shareholders:  

Questions You Were Afraid to Ask #16: What are dividends, stock buybacks, and stock splits?

They are the kind of terms that frequently make headlines in the Wall Street Journal or on CNBC.  “Company X increases their dividend to $2.50 per share.”  “Company Y announced a new buyback program of their shares today.”  “Investors debate Company Z’s plan to split their stock at two-for-one.”  You get the idea. 

But what do these terms actually mean? 

What Does Free Cash Flow (FCF) Mean?

To understand these terms and why they matter, it’s helpful to first define another term: Free cash flow, or FCF.  Free cash flow represents the total amount of cash that a company generates after accounting for both its operating expenses and its capital expenditures.  (The former represents the costs of running the business on a daily basis; the latter refers to long-term investments, like acquiring machinery or building a new warehouse.) 

FCF, then, is all the cash a company earns that is completely free of debt or obligation.  That cash can be used however the company wants.  For example, a company can reinvest the cash back into itself to improve operations, expand into new markets, or even acquire other businesses. 

Alternatively, the company can use its FCF to return value to its investors. 

This, ultimately, is why people invest in the first place: Because they expect the free cash flow a company generates to be eventually returned to them.  When investors expect a company to generate more FCF in the future, they tend to buy more stock…thus increasing the stock price. 

So, how do companies actually return value to investors?  Well, that’s where two of today’s terms — dividends and buybacks — come into play. 

What Are Stock Dividends?

Many companies return value by paying a percentage of their profits to shareholders, usually every quarter and usually in the form of cash.  For example, imagine you owned 100 shares in the ACME Corporation.  ACME generates a lot of free cash flow, so they distribute a dividend of $0.75 per share.  That means for every share you own, you receive 75 cents each quarter.  Since you own 100 shares, your payment would total $75.  If you owned more shares, or if ACME paid a higher dividend per share, then you’d earn even more. 

Dividends are important for several reasons.  First, they can be used as a form of income.  It’s nice to get a check every quarter!  However, many financial advisors often recommend younger investors to reinvest their dividends.  (That means using the money to buy more shares.)  In the long run, that enables them to benefit even more from the company’s free cash flow.  Once investors retire, however, it can then make more sense to use the dividends as income.

Dividends are also important as a handy barometer for a company’s health.  You can look to see how long a company has paid dividends and how those dividends have gone up over time to estimate the company’s financial situation.  Dividends don’t always tell the whole story, though, as companies can increase their dividends as a way to distract investors from other problems.  Furthermore, many companies do not pay dividends…but that doesn’t mean they’re not worth investing in!  After all, there are other ways to return value to shareholders, including:

What Are Stock Buybacks?

Companies can also use cash to repurchase their own shares from investors.  This is often done when a company’s management feels its shares are undervalued — that is, trading at a lower price than they actually should be.  Alternatively, a company may launch a stock buyback because it wants to demonstrate it has more than enough cash set aside for the future.  Either way, when a company buys back a portion of its shares, it effectively decreases the total number of shares available.  This, in turn, makes each remaining share worth a greater percentage of the company.  The end result?  The stock price often goes up, thus benefiting the company’s shareholders.  

I’ve been asked which is better, dividends or buybacks?  The answer is it depends.  Dividends tend to be more predictable and can be either reinvested or used as income.  Buybacks tend to affect a company’s stock price more in the short term.  Either can be effective at returning value to investors. 

What Are Stock Splits?

The final term I want to cover has nothing to do with returning value, but I include it because it’s something you often hear in the financial media.  A stock split is when a company increases the number of shares.  This is done by splitting each share into several new, smaller shares, such as 2-for-1 or 3-for-1.  This effectively makes each share worth a half or a third as much.  However, because the company’s market capitalization — see my earlier newsletters for more on this term — remains unchanged, a split does not affect the overall value of an investor’s shares.

Why would a company split its stock?  Usually, it’s because the share price has risen so high that it makes it harder for new investors to buy stock in the company.  A stock split decreases the price per share, allowing new investors to participate at a more affordable price.