Q: Some stocks pay big dividends, while others choose to buy back shares with their profits. Which is better?

Companies can choose to use their earnings in two main ways: They can reinvest in the business, or they can share their profits with investors. Or, they can do a combination of the two.

When it comes to sharing profits with investors, many companies pay dividends, which are cash payments made to shareholders. The other possibility is to buy back stock, also known as share repurchases. The idea behind share repurchases is that if there are fewer shares of a stock, the remaining shares will represent more equity in the company, and will therefore be worth more.

So, which is better for you as a shareholder?

The short answer: It depends. Dividends have the obvious advantage of putting money in your pocket, which you can then choose to do whatever you want with. You can reinvest your dividends, or you can withdraw them from your account. However, keep in mind that dividends are considered a form of income, and can be subject to income tax unless they're paid on stocks you hold in a retirement account.

On the other hand, buybacks have the advantage of not immediately adding to your taxable income, since you don't pay tax on capital gains until you sell.

Buybacks can also be the better option if the company considers its own stock to be undervalued. As an example, during the past couple of years, there have been times when Bank of America stock was trading as low as half of its book value. So, by aggressively buying back shares, the company was literally buying back its own assets at a fraction of what they were worth.

The bottom line is that if you rely on your investments for income, or if the stock trades for a high valuation, a dividend is probably preferable to you. If you don't, and the stock trades at an attractive valuation, buybacks can be a more advantageous way for the company to return capital.

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Matthew Frankel owns shares of Bank of America. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.