Stock repurchases (share buyback)

October 27April 26Firmsconsulting 1 Comment

Stock repurchases is a form of dividends. If stock repurchases are made instead of cash payment, it increases the earnings per share of current shareholders and it increases the market price per share.

Market price per share increases because earnings available for distribution to shareholders are now divided among fewer shareholders. Share price also increases because when a firm is buying back its shares it sends a positive signal to the market that management considers shares undervalued. Of course, repurchasing stock is especially beneficial for firm to undertake if the share price is really perceived by management to be undervalued.

Repurchase of stock also discourages unfriendly takeovers. This happens firstly because takeover can be attractive due to a company’s liquidity position. If a company has a lot of cash, it can be used to cover the debt undertaken to finance the acquisition. By using available cash to repurchase stock, a firm decreases its attractiveness as a takeover target. Moreover, repurchase of shares increases the price per share which makes takeover more expensive.

Another benefit of repurchase of stock is that it delays the tax liability of the shareholders. If cash dividends are paid out to the shareholders, then shareholders will have to pay part of it to the government as taxes. Repurchase of stock delays taxes that shareholders will be liable for until capital gain is realized, which occurs when shareholder sells stock.

Agency problem also have something to do with managements’ incentive to repurchase stock. Executive’s rewards are often tied to performance measures such as earnings per share. If firms have fewer shares outstanding and earnings stay the same than its earnings per share will inevitably increase.

Therefore, a part of the agency cost that firm has to incur is due to a necessity to monitor management actions to ensure that stock is not repurchased because an executive’s compensation is tied to EPS measure.

Repurchase of stock also allows a firm to have shares available for employee stock option plans. Buying back shares also temporarily provides a higher floor for the stock price.

Shares repurchase methods

The most common share repurchase method is purchasing shares on the open market. A second option is to negotiate with major stockholders to purchase a large bulk of shares. Another option is a formal fixed price tender offer that can be made to purchase shares at above market price.

Dutch auction tender offer, which originated in 1981, is another option to repurchase stock. This option entails invitation to shareholders to tender their shares at prices within ranges established by the firm. The firm will try to purchase shares at the lowest possible prices. Thus, if more than enough shares are tendered then shares will be purchased up to a certain price at which an adequate amount of shares will be available. If not enough of shares are tendered then firm can either cancel the offer or buy back all the shares tendered.

Under every method of shares repurchase the reasons behind repurchase of shares must be clearly stated to the shareholders. The intention as to how repurchased shares are intended to be used should also be communicated. For example, it can be used for executive compensation or for trading it in exchange for shares of another firm.

In conclusion, companies need to maintain a target payout ratio which is suitable for the company’s needs. Organizations must also try not to neglect acceptable projects (with NPV higher than zero and IRR greater than weighted marginal cost of capital) to pay out large dividends. The main objective, as always, should be owner’s wealth maximization.

Also it is important to remember that whereas it is important to try not to decrease dividends to ensure that no negative signals are sent to the market, it is also important to maintain a healthy liquidity position. Organizations certainly should not borrow to be able to pay out large dividends.

Dividend irrelevance theory

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This theory was proposed by two Noble Laureates, Merton H. Miller and Franco Modigliani, and is also commonly called the M and M theorem. The theory was proposed in their article “Dividend Policy, Growth, and the Valuation of Shares,” which was published in the Journal of Business in October of 1961, pp. 411-433.

The theory suggests that, in a perfect world, dividends are irrelevant when the value of the stock and, therefore, of the firm is determined.

The theory implies that retained earnings belong to the shareholders of the company and shareholders are not concerned whether money is used to pay out dividends or for investment purposes because they benefit either way by receiving dividends or via share price appreciation.

If investors will require cash, they can always sell a few of the shares which increased in value due to investments.

Miller and Modigliani also suggest that the clientele effect exists. This refers to the tendency for investors to hold stocks which are in line with their dividend payment preferences.

Investors who prefer regular dividends hold stocks of the companies which provide such dividends and investors who prefer for funds to be reinvested and to be reflected in the share appreciation hold those stocks that are aligned with such preferences.

The clientele effect further supports the proposition that the dividend policy does not affect the value of the stock because investors obtain income from the shares in their preferred way.

Miller and Modigliani also suggest that if dividends affect stock price than it is because of the informational content in changes in dividends. Investors see changes in dividends as signals. Increases in dividends are seen as a positive signal pointing out that management expects earnings of the firm to increase in the future. Decrease in dividends is seen as negative signal which points out that management expects earnings to decrease in the future.

Overall, the dividend irrelevance theory suggests that firm do not require a dividend policy because it does not affect the value of the firm.

Declaring and payment of dividends

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The board of directors determines whether or not dividends will be declared for the current financial period. Such decisions are made during semi-annual or quarterly meetings of the board of directors.

If a decision to distribute dividends is made, it will be paid to all shareholders whose names are listed as shareholders on the record date.

Due to time that it takes for new shareholders to be listed, dividends are only paid out to those shareholders who acquired shares of the firm earlier than two business days before the record date.

Two business days prior to record date, along with usual fluctuations of the market, the stock price starts selling as ex dividend and drops by an amount close to the declared dividend. The payment date of the dividend usually occurs few weeks after the record date.

Test yourself:

ABC Company declared a quarterly dividend of $0.5 per share on 15^th of November. You purchased 800 shares of ABC on 1^st of November and 15% tax is applicable to any dividends received. Determine whether you are eligible to receive dividends and, if so, how much will you receive after tax is taken into account.

Solution:

The dividends were declared on 15^th of November. Since you purchased stock on 1^st of November, you are eligible to receive the dividends. Your before tax dividends amount to $400 (=800*$0.5). Your after-tax dividends amount to $340 (=$400*(1-.15)).

Dividend reinvestment plans (DRIPs) – many firms offer dividend reinvestment plans which allow current stockholders to use dividends to acquire more shares at about five percent below the market price of the firm’s shares.

This allows company to avoid under pricing and flotation costs involved in issuing new shares and shareholders also benefit due to lower prices per share. This arrangement makes obtainment of additional shares more attractive for current stockholders.

Dividend relevance and irrelevance

Whether dividend policy affects the share price and, therefore, a value of the firm is still an unresolved issue. Residual theory of dividends, the dividend irrelevance theory proposed by Merton H. Miller and Franco Modigliani, and dividend relevance theory proposed by Myron J. Gordon and John Lintner, provide different viewpoints on the issue and are briefly discussed in the next set of articles.

Importance of dividends and dividend policy

October 27October 18Firmsconsulting Leave a comment

Dividends are payments made by an organization to its shareholders from earnings generated in current or previous periods. Shareholders earn income from two sources, the capital gain due to appreciation of share and dividend yield. Dividend yield is calculated by dividing the current dividend by the price of a share.

Test yourself:

You purchased shares of ABC Company for $50 per share. Two months after the purchase of shares you received a dividend of $3 per share. What is the dividend yield on the ABC shares?

Solution:

The dividend yield = 3/50=6%.

The stock value is determined based on the present value of all expected dividends to be received from share over the infinite future period that firm is expected to be operational. Expected cash dividends give an indication of the firm’s current and future performance.

The constant growth valuation model can be used to evaluate the expected growth of a share price. The formula for the constant growth valuation model (Gordon model) is as follows: Po=D1/(r-g). As can be seen from this formula, if dividends do not grow then the share price will stay the same as long as required return stays the same. Assuming that required return is constant, for a share price to grow the dividends need to grow as well.

Test yourself:

ABC’s dividends over last few years were as follows:

2010: $3

2009: $2.9

2008: $2.4

2007: $2.3

2006: $2.1

2005: $2

The required return is 12%. What is the price of the share? What would be the price of the share if growth of the dividends were zero and the next period’s dividend would be $3.25?

Solution:

First we need to find the growth rate with the help of a financial calculator. The calculation is as follows:

PV: -2

FV: 3

N: 5

I: calculate = 8.45%

The ABC’s share price is found with the help of the Gordon model Po=D1/(r-g):

Po=3*(1+.0845)/(.12-.0845)

Po=3.25/.0355

Po=$91.65

To find the share price if the growth of dividends were zero we would use the formula Po=D1/r (for zero growth valuation model)

Po=3.25/.12

Po=$27.08

Without growth in dividends, ABC’s share price is valued to be significantly lower.

Dividend policy is less important than capital budgeting and capital structure decisions. However, generally, dividend policies are expected to influence the price of shares.

Cash dividends are paid out of the retained earnings. Retained earnings are an internal source of financing. Therefore, if a business requires financing then the bigger the cash dividends, the higher the amount of external financing will be required. External financing can be in the form of debt or equity.

Note: If you struggle with a calculation, read using a financial calculator article for some simple tips on using a financial calculator.

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Times Interest Earned Ratio (Interest Coverage Ratio)

October 27October 18Firmsconsulting Leave a comment

Times Interest Earned Ratio (TIER), also known as the Interest Coverage Ratio, measures the ability of the enterprise to meet its financial obligations (interest payments on debt due). The formula for TIER is as follows:

Times Interest Earned Ratio = EBIT/interest charges

EBIT refers to earnings before interest and taxes, which is also called operating profit (refer to the format of an income statement to see how it is calculated).

Example

Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The Times Interest Earned Ratio (TIER) of ABC is as follows:

$550,000/$100,000=5.5

It is generally advisable that the Times Interest Earned Ratio should be between 3 and 5.

ABC’s Times Interest Earned Ratio (TIER) could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk taken may be lower than average, but so is the return.

Things to note about this ratio

When using the Times Interest Earned Ratio (TIER), it is important to remember that interest is paid with cash and not with income (since some income may still be in the form of accounts receivable). Therefore, the real ability of the firm to make interest payments may be worse than indicated by the Times Interest Earned Ratio (TIER). It is also important to remember that debt obligations include repayment of principal debt as well as payment of interest.

One should compare debt ratios of individual firms to industry averages, to obtain a better understanding. There is a large variability of debt ratios industry averages between industries. This is because different industries have different operations requirements.

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Sign up to receive a 3-part FREE strategy video training series here.