How Companies Reward Shareholders: Dividends, Buybacks, and Splits

The financial media regularly highlights announcements like:

“Company X raises its dividend to $2.50 per share”

“Company Y launches a $5 billion stock buyback program”

“Company Z announces a 2-for-1 stock split”

These headlines are common, but the underlying concepts aren’t always clearly explained. Dividends, stock buybacks, and stock splits are all actions a company can take that may affect its shareholders—but each works in a different way and serves a different purpose.

Before looking at these three terms, it’s helpful to understand a key concept that connects them: free cash flow.

First, What Is Free Cash Flow?

Free cash flow (FCF) is the amount of cash a company generates after covering its operating expenses and capital expenditures. Operating expenses include the costs of running the business—such as payroll, rent, and utilities—while capital expenditures are long-term investments like purchasing equipment or expanding facilities.

Free cash flow represents the funds a company has available to allocate as it sees fit. Some companies may choose to reinvest in growth opportunities, while others may use the cash to return value to shareholders.

Returning value to shareholders is a key reason investors buy stock in the first place. When a company is expected to generate strong free cash flow in the future, demand for its stock tends to increase—often pushing the stock price higher.

Two of the most common ways companies return cash to shareholders are through dividends and stock buybacks.

Dividends

A dividend is a portion of a company’s earnings that is distributed to shareholders, typically on a quarterly basis and usually in cash. For example, if a company pays a dividend of $0.75 per share and an investor owns 100 shares, the investor receives $75 each quarter.

Dividends can be used in two ways:

• Reinvested, to purchase more shares and potentially grow long-term wealth.

• Taken as income, which is more common in retirement.

In addition to providing income, dividends can serve as a signal of financial strength. Companies with consistent, growing dividend payments are often seen as stable and profitable. However, it’s important to note that not all companies pay dividends—and some may increase their dividend to offset other concerns. A dividend alone doesn’t tell the full story of a company’s financial health.

Stock Buybacks

A stock buyback occurs when a company uses its own cash to repurchase shares from the market. This reduces the total number of shares outstanding, increasing each remaining shareholder’s ownership percentage in the company.

Buybacks may be initiated for a variety of reasons:

• The company believes its stock is undervalued.

• Management wants to improve financial metrics like earnings per share.

• The company has excess cash and no immediate need to reinvest it.

Unlike dividends, buybacks don’t result in a direct payment to shareholders, but they can have the effect of raising the stock price over time.

Which is better—dividends or buybacks? It depends on an investor’s goals. Dividends offer regular, predictable payments. Buybacks are more flexible and may offer tax advantages. Both are tools companies use to return value to shareholders.

Stock Splits

A stock split does not return value to shareholders, but it’s often mentioned alongside dividends and buybacks in the financial news.

In a stock split, a company increases the number of shares outstanding by dividing existing shares into smaller parts—such as a 2-for-1 or 3-for-1 split. While the number of shares increases, the total value of an investor’s holdings stays the same. The stock price is simply reduced in proportion to the split.

For example, in a 2-for-1 split, a stock trading at $200 would become two shares trading at $100 each.

Why do companies do this? Primarily to make their stock more accessible to individual investors by lowering the share price. Stock splits can also signal confidence from management, but they do not directly affect a company’s value or fundamentals.

Understanding how dividends, stock buybacks, and stock splits work can provide clarity when evaluating a company or interpreting financial headlines. While each of these actions is different in purpose and impact, all three relate to how companies manage capital and engage with their shareholders.