What is the difference between dividends and share buybacks?

Although both methods are a way of rewarding shareholders, they can be significantly different in terms of what it means for the business and what it means for the individual shareholders.

With a dividend, shareholders are paid a monetary value per share, which is then taxed at that time. They could be looked upon as a solution for rewarding shareholders in the short term.

In the case of a share buyback, however, the business buys a number of shares back from the market, aimed at consequently increasing the value of the shares that are held. For the shareholders, any money that they make is only taxed when the shares are sold. Share buyback could be looked upon as a longer-term option than paying out dividends, as the cash stays within the company for more time.

The more shares that are out there, the lower the value of each share. The idea of a share buyback, therefore, is that the number of shares that are available reduces. This is made with the intention of increasing the value of each individual share so that when a shareholder sells their shares, they are worth more money.

Share buybacks are usually preferable for small and new businesses as paying out dividends can affect cash flow. Share buybacks are seen as a sign of confidence in the business but can also be risky as there is the chance that the value of the shares could go down.

Dividend payments can only be made from company profits, whether from that financial year or previous financial years if profits have been retained within the business. You should not and cannot pay dividends if the company is not making a profit.

Apart from being against the rules, paying out dividends that the company cannot afford is unsustainable and it can soon lead to serious cash flow problems or worse – it can kill a company.

And for companies with less predictable/uniform monthly revenue or sales or income, it can make dividend payments less predictable/uniform, which could also mean that dividend payments some months are not possible. This may cause professional and personal cash flow issues, which you may need to budget for or overcome.