Company with excess cash flow has two options to return the money to shareholders. One is to give out dividends. The other one is to initiate a stock buyback program.

Stock buyback is a program where a company use its cash to buy back its own stock at an open market. The purpose is to reduce the amount of shares outstanding and thus causing the remaining shares to be more valuable. Company initiating a stock buyback program will be able to grow revenue more rapidly and afford to pay bigger dividends. Let's use an example to illustrate. Ready? Please write it down on a piece of paper if you must.

Company A is trading at $ 20 per share with 100 Million of shares outstanding. It earns $ 2 per share at recent years and it is giving out $ 1 per share of dividends. If you do the math, this translates into $ 200 Million of annual profit and $ 100 Million of dividend payments. Now, let's assume that company A is distributing all its profit to shareholders. With $ 100 Million used for dividend payment, management decide to use the rest of $ 100 Million to buy back its own shares. Meanwhile, the company manages to grow its profit by 5% in the following year to $ 210 Million. What is the effect of the buyback? The following table will illustrate. (The table can be viewed at http://www.noviceinvesting.com/Research71.php)

Looking at the result, stock buyback obviously increases the growth in earning per share. In an actual basis, earning grew from $ 200 Million to $ 210 Million, or a 5 % growth rate. Earning Per Share (EPS) however, grew at a much faster rate. It grew from $ 2.00 to $ 2.21 representing a 10.5 % growth rate. Meanwhile, dividend payment shrank due to the shrinking number of shares outstanding. The company still gives $ 1 per share dividend but it costs them $ 5 Million less now.

Do it over a longer time frame and the EPS increase will be much larger, assuming that the stock price remains stagnant at $ 20 per share.

There is several lessons that we can learn from stock buyback. One is that investors won't have to worry if the stock price remains stagnant. The company can keep buying back its shares, reduce its share count and increase Earning Per Share even faster.

The second lesson is that stock buy back will reduce the cost of distributing dividends. As less shares are available, the company can afford to increase its dividend per share even when the total dividend distributed remains constant.

The third lesson is that the cheaper a stock price is, the larger amount of shares the company can buy back. This is positive for shareholders! If the company buy more shares at a low price, the effect of EPS increase will be higher with the same amount of dollars. Thus, investors often applaud companies that initiate stock buy back when their stock price is depressed.

What kind of companies can afford to buy back its own stock while initiating dividend? These are mainly companies that require less capitals to fund its ongoing business and they should be profitable. In other words, they have excess cash. Buying companies with positive net cash also helps. Management may decide to buy back its own stock when they cannot find better use of its cash.