Here's a statement you won't expect to hear from a dividend guy: If executed properly, share repurchases are likely to be more beneficial to shareholders than dividends are. Why? Because dividends are taxed and share repurchases are not. But for the potential value in a share repurchase to be realized, a company's management needs to disconnect itself from what it sees as the future potential of the company or stock. Management must then determine whether the company's shares as they are currently priced offer a discount to their intrinsic value. Most importantly, management needs to resist the urge to reach for the extra penny or two of earnings per share that buybacks can provide.

What about dividends that are regularly paid in cash? While taxes make dividends less efficient, dividends are still generally more beneficial because they don't require management to value its own shares properly. Nor do they require the shares to be priced attractively to be an effective means of returning cash to the owners of the company (i.e., the shareholders).

When companies pay too much
General Electric (NYSE:GE) has repurchased billions of dollars' worth of shares every year for the past five years. GE views its share repurchases as a way of returning cash and value to shareholders -- and most of the time it is. However, when GE's shares were hovering between $50 and $60 in 2000 and parts of 2001, its share repurchases were actually harming shareholders as a poor use of capital.

At that time, GE shares traded at price-to-earnings ratios (P/Es) above 30 -- for a stretch, the P/E was even above 40. For a company that was expecting 10% to 15% growth in earnings and free cash flow, it was clear that the shares were ahead of themselves and that share repurchases should have been suspended.

Hindsight is 20/20, of course, and the point here is not to slam GE, which has rewarded shareholders for decades by managing its business extremely well, paying dividends, and, yes, by repurchasing shares. Rather, the GE example shows that share repurchases are most effective when they are turned on when shares are cheap and turned off when shares are expensive.

When shares leak out the back door
In the past, I've written a few negative articles about Cisco (NASDAQ:CSCO). Don't get me wrong: I don't think Cisco is a bad company. My beef with Cisco is that its management doesn't treat all shareholders equally. There is a solid company behind the shares, but, unfortunately, I don't believe common shareholders benefit as much as management does from the company's success.

CEO John Chambers recently said that the company is "agnostic" as to whether it pays a dividend. While that may be so, I believe outside shareholders would be much better off receiving a dividend along with the large share buybacks that have been made the past few years -- even if that means scaling back the buyback program a bit. Over the past three years, the majority of Cisco's share repurchases have gone toward absorbing the dilution from options issuances -- not toward benefiting shareholders.

Cisco Share Repurchases and Option Issues 2005 2004


Shares Repurchased 540,000,000 408,000,000 424,000,000 124,000,000
Shares Issued n/a 187,969,925 194,514,686 279,759,407
Net Shares Repurchased n/a 220,030,075 229,485,314 -155,759,407

It's important to consider what Cisco is paying for these shares and at what price they are issuing them. However, I left this data out because the prices pretty much average out for the past few years. We don't know how many shares the company has issued for 2005 -- its proxy statement will not be filed for another month. Between 2002 and 2004, Cisco purchased 956 million shares and issued 662 million shares of options. In other words, approximately 69% of the shares that Cisco purchased in the open market from 2002 to 2004 were issued to employees as options. The cost of those shares is billions of dollars in free cash flow that Cisco generated -- Cisco is a free cash flow machine -- and then redirected back to employees and away from shareholders.

Foolish final thoughts
As an investor who seeks dividend-paying companies -- and as a member of the Motley Fool Income Investor team -- I prefer companies that have a commitment to regularly paying a dividend and increasing that payout over time. But I like it even more when I find a company that augments its commitment to paying dividends by buying back shares when they are cheap. Diageo (NYSE:DEO), Nutraceutical (NASDAQ:NUTR), Buckle (NYSE:BKE), and Outback (NYSE:OSI) are four companies across very different industries that fit this mold, and, except for a couple of years, GE also fits the mold.

However, not all CEOs and management teams possess the ability to accurately value their shares and separate what is best for management from what is best for shareholders. The presence of a dividend acts as a curb on stock option grants -- each additional share that comes into existence requires that a company lay out a little more cash to pay its dividend. And when you're talking millions of shares, what appears to be a small dividend payment can end up being a large price to pay.

Diageo is a Motley Fool Income Investor selection. If you're interested in learning more about companies that generate robust free cash flow and pay you to hold them,consider afree 30-day trialto Income Investor. Over the past two years, lead Income Investor analyst Mathew Emmert has delivered an average total return of 15.2% against the S&P 500's 9.5%. There's no obligation to buy if you aren't completely happy.

Nathan Parmelee owned shares in Nutraceutical at the time of publication but has no financial interest in any of the other companies mentioned. You can view his profile here. The Motley Fool has an ironclad disclosure policy .