Stock buyback vs dividend investing may seem a clear-cut choice, but savvy investors will tell you that they can complement one another quite well

Stock buybacks, also known as share repurchases, are when a company buys outstanding shares of its own stock on the open market.

A dividend is a payment a corporation makes to its shareholders, usually as a distribution of profits or cash flow. When a corporation earns a profit or has strong cash flow, it can re-invest that surplus in its business—or distribute some of it as a dividend to its shareholders.

A company can share the wealth in two main ways—it can buy back its own shares, or it can pay dividends. Both pay off for investors, which is why a number of the best stocks we recommend have a history of doing both.

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Stock buyback vs dividend investing: What to know about stock buybacks

Stock buyback programs raise a company’s earnings per share. It’s simple arithmetic: buybacks reduce the number of shares outstanding. To get earnings per share, you divide total earnings by the number of shares outstanding. When you reduce the denominator—because the company has fewer shares outstanding due to stock buybacks—the calculation gives you a higher value for earnings per share.

On the whole, buyers are willing to pay more for a stock with higher earnings per share.

Furthermore, there are tax advantages to share buybacks. There are no tax implications for shareholders when a company buys back its stocks. However, when you hold a stock in your personal, taxable account and it pays a cash dividend, you have to pay tax on the dividend in the year in which you receive it. But at the same time, of course, you have use of the after-tax cash.

If the company instead devotes the cash to a stock buyback, here’s how you can match that up with your cash flow needs:

• You can sell part of your holding in the stock, presumably at a higher price than you’d have gotten in the absence of a buyback. If you do that, you’ll only pay taxes on the sale if the stock has moved up since you bought. If the stock has moved sideways or down, the proceeds of your sale are tax-free.
• Of course, if you don’t need cash right away, you always have the option of holding on to your stock until it suits your purposes to sell. That may not be until you retire—when your income tax rate is likely to be lower.

Stock buyback vs. dividend investing: What to know about dividends

A dividend is allotted as a fixed amount of money per share so that shareholders receive a payment that is proportionate to the shares they hold. Most dividends are paid quarterly, although some companies pay a monthly, or even annual dividend.

Dividends can be an important contributor to your long-term gains, and dividend-paying stocks tend to expose you to less risk that non-dividend-payers. That’s why the majority of your stocks should be dividend-payers at all times.

Stock buyback vs. dividend investing: The two can complement each other

Picking stocks whose share prices will rise is not the only goal that successful investors set for themselves. You also add a great deal of value to your portfolio when you select stocks that are prepared to distribute their profits to the shareholders when that’s the best option.

A company can share the wealth in two main ways—it can buy back its own shares, or it can pay dividends. Both pay off for investors, which is why a number of the best stocks we recommend have a history of doing both.

Here are three ways in which you can benefit from those companies that reward their shareholders with both share buybacks and dividends: 

• As mentioned, a company boosts its per-share profit by buying back its shares because profits get divided among fewer shares.
• Boosting per-share profits can also push up share prices. Plus, buybacks let you defer taxes on those capital gains. That’s because you only pay capital-gains taxes when you sell. What’s more, you’ll pay tax at half the rate on capital gains than you would on ordinary income. And you can offset capital gains with capital losses.
• Dividends have tax advantages. You’ll pay tax on dividends in the year you get them, if you hold the shares outside your RRSP. However, dividends on Canadian companies receive favourable tax treatment in Canada, thanks to the dividend tax credit. 

More on the dividend tax credit 

Canadian taxpayers who hold Canadian dividend stocks get a special bonus. Their dividends can be eligible for the dividend tax credit in Canada. This dividend tax credit—which is available on dividends paid on Canadian stocks held outside of an RRSP, RRIF or TFSA—will cut your effective tax rate.

This means that dividend income will be taxed at a lower rate than the same amount of interest income. Investors in the highest tax bracket pay tax of around 29% on dividends, compared to 50% on interest income. At the same time, investors in the highest tax bracket pay tax on capital gains at a rate of about 25%.

Above all, pick stocks that fit into our Successful Investor philosophy

Stock buyback can be a huge win for investors. And you can make even bigger gains in the market by following TSI Network and using our three-part Successful Investor strategy:

• Invest mainly in well-established, mostly dividend-paying companies;
• Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities);
• Downplay or avoid stocks in the broker/media limelight.

Some investors argue against stock buybacks because they say it undermines innovation and future prospects. Why do you agree or disagree?

How do you combine stock buybacks and dividend stocks to get the best results from your portfolio?