Some companies pay a high dividend resulting in a high yield. Other companies pay a low dividend and may increase the payment over time. Lastly, some companies do not pay dividends at all. The best option depends on the company and is just a part of a company’s overall capital allocation.

How a company allocates its capital is arguably the most important driver of its long-term success in generating shareholder returns. A company generates cash from its operations. It then uses some of that cash for capital expenditures, which is money spent on acquiring and maintaining fixed assets, such as land, buildings, or equipment. The remaining cash is called Free Cash Flow (FCF).

The FCF can be used to pay dividends as well as buyback stock, acquire other companies, pay down debt, or to drive organic growth, e.g., increasing the research and development budget. Paying a dividend is arguably the most conservative approach as it’s a direct return to the shareholder, but that doesn’t always make it the best option. If a company returns $100 million to its shareholders via dividends, the shareholders can take that money and invest it back in the market, earning a return of 10% based on historical averages. However, if a company has returns on capital of 15%, it makes more sense to invest the $100 million back into the company, which in turn drives earnings growth, typically resulting in a higher stock price.

Altria Group is currently the highest yielding company in the S&P 500 at over 9%. Over the last 12 months, the company generated about $8.5 billion in FCF. Over that same period, it paid out about $6.7 billion in dividends. Altria sells cigarettes. It’s unlikely that investing an extra $6.7 billion in the company would drive earnings much higher. The best use of the company’s FCF is to return it to its shareholders.

Alphabet does not pay a dividend. Over the last 12 months, the company generated $77.6 billion in FCF. Instead of dividends, the company returned cash to shareholders via $60.7 billion in stock buybacks. Buybacks lower the share count, increasing earnings per share and therefore increasing the value of the stock. Buybacks afford more flexibility than dividends. Once a company starts paying a dividend, cutting the dividend, or canceling payment, is viewed negatively by the market. Changes to the buyback plan are not viewed in the same light. Alphabet also spends FCF on acquisitions – averaging about 6% of FCF over the previous five years. Ultimately, Alphabet continues to invest in the growing online advertising market as well as in new technologies such as artificial intelligence.

Stryker is an example of a company that pays a small dividend which has grown about 10% per year over the last five years. The stock yields 1% and is not really considered a dividend stock. The company has not repurchased any shares in the last three years. Instead, over the last five years, the company has typically spent a large portion, about 50% of its FCF, on acquisitions. Stryker is a medical products company that will purchase early-stage companies with differentiated products and expand the market for the products through its distribution network.

These examples and the general breakdown of FCF illustrate that the decision is not only about whether to pay or not to pay a dividend. It is in fact the outcome of the process by which a company must determine the optimal way to allocate capital. This differs for each company based on its end market as well as other factors. An incorrect allocation can lead to the demise of a company – consider the AOL-Time Warner merger. Conversely, the correct allocation can lead to high returns for shareholders through both dividends and stock appreciation. A prudent investor must understand the rationale underlying the capital allocation decisions and make a judgment as to whether or not they are correct.