I’m a little confused. In the material it says that after a share repuchase is completed, the market value of the stock will be unchanged. So if this is the case, how is a shareholder any better off? i.e. why even do it? How is this a transfer of wealth to the shareholder? What am I missing?
The company intervenes in the market to buy its shares (think about it in terms of supply/demand) Share price goes up # of shares goes down Overall capitalization remains unchanged Shareholders are happy because their shares are worth more. That being said, a lot of dudes believe that this is a guimmick that only works in the short term and that long term the shareholders are not any better off. Personnally, I believe that share repurchase only make sense if the company can buy share back at less than book value.
olivier Wrote: ------------------------------------------------------- > Shareholders are happy because their shares are > worth more. Thanks for the response! I think this is what I’m missing. If the stock trades at $50/share before and $50/share after. Then how are the shares “worth more”?
The shareholder is better off because, even though the total market cap of the company is the same, there are less shares outstanding and the shareholder holds a greater claim on earnings. A share repurchase is essentially the same as paying the excess earnings out as dividends. If the shareholders prefer the cash, the could sell shares (worth the excess benefit from the repurchase) for cash. Likewise, if the shareholders received a dividend but would prefer to have additional interest in the company, they could use the dividend cash to buy additional shares (to hold the same claim on earnings that they would have had with a repurchase). This parity assumes zero transaction costs and tax indifference.
The share price will rise after the repurchase because the shareholder will have a greater claim on earnings, all else equal. Only the total market cap is the same.
Before, we had 10,000 shares worth $50/share After, we have 9,900 shares worth $50.50/share Capitalization remains unchanged at $500,000 but share price goes up. That was my first impression. I start to feel confused. Could you direct me to the page (reading # & page #) in the reading discussing this so that can make sure that I understand this correctly? Thanks.
In the book it says that market value of equity would decrease by (using your numbers) $5000 because when you use your cash to repurchase, equity falls by 5,000 as well so that the balance sheet balances. So the numerator would be (10,000 shares *50/share) - (100 shares repurchased *50/share) divided by 9900. This gives you a share price of $50 after repurchase In the Schweser book, a similar example is in Book 3 pg. 93. In the Stalla books, a similar example is in pg. 73 of Study Session 8 Sorry to confuse you - before coming across this and a table in the Stalla videos, I too thought that share price was greater because of the smaller shares outstanding - hence why I am now very confused.
Oh, ok, go to Example 1 on page 150 (reading 33), and it shoudl make sense. The share price before was $20. With cash dividend, shareholders would have $5 cash + a share (worth $15) With share repurchse, shareholders still have a share worth $20 Either way, the market cap. is decreased by the amount of cash distributed (thru dividend or repurchse) To determine which option is more favorable to shareholders, you would have to look at the different tax rates applied to dividends vs capital gains. Please disregard the previous posts on this thread.
Gotcha - but I guess my original question still remains: If dividend and repurchase both give shareholder value of $20, how is this any better than doing nothing and letting shares continue to trade at $20? Thanks for your help on this!
Well, the company pays out dividends in a way or another when it does not have any investment opportunity that would yield a positive NPV. If the company keeps the cash, returns will not meet the cost of that cash (i.e. WACC). Not to mention that if a company keeps to much cash when it does not have profitable investment opportunities, they may do something stupid that yields good return to the CEO but are detrimental to the shareholders (investments and/or mergers without economic reasons) From page 144 “We emphasize in this reading that the overriding consideration in determining a company’s dividend payout policy is whether it has positive NPV reinvestment opportunities …”
If there is a repurchase, the value per share WILL rise above $20 once the repurchase is announced. The total market cap will remain the same, not the share price. If there is a dividend payment, the share price will NOT rise but the shareholder will hold excess cash equal to the amount that the shares would have risen by if there was a repurchase (actually the share price will rise by the amount of the dividend once it is declared but then drop by the amount of the dividend after it is issued). If no dividend is issued, the shareholder won’t receive the benefit from the increased share price OR the additional cash. So they will be worse off by the amount of the dividend. This of coarse is holding all other factors constant and assuming that ROE <= required return on equity. If ROE is significantly greater than the required return on equity, the earnings should be reinvested in the firm.
McLeod81 : your last post is contrary to Example 1 on page 150 (reading 33) in the CFA reading
McLeod81 Wrote: ------------------------------------------------------- > If there is a repurchase, the value per share WILL > rise above $20 once the repurchase is announced. > > The total market cap will remain the same, not the > share price. > > If there is a dividend payment, the share price > will NOT rise but the shareholder will hold excess > cash equal to the amount that the shares would > have risen by if there was a repurchase (actually > the share price will rise by the amount of the > dividend once it is declared but then drop by the > amount of the dividend after it is issued). > > If no dividend is issued, the shareholder won’t > receive the benefit from the increased share price > OR the additional cash. So they will be worse off > by the amount of the dividend. > > This of coarse is holding all other factors > constant and assuming that ROE <= required return > on equity. If ROE is significantly greater than > the required return on equity, the earnings should > be reinvested in the firm. To rephrase that, if there is already a stable dividend policy then the stock price will drop by the amount of the dividend once it is issued but the total value is still $20 (div + cash). If the company repurchases shares instead of issuing a dividend in this case, the value will stay at $20 (if the dividend payout ratio is already priced into the stock). If the dividend policy is new, assuming that req return equity, earnings and growth rate are constant: P/E = (D1/E) / (r-g) Initiating or increasing the payout ratio (through dividends or share repurchases) will increase the price of the sock. The example on P. 150 assumes that the dividend policy is already priced into the stock. If the company does not pay the dividend or suspends the dividend policy (does not issue dividend or repurchase shares) the price of the stock will fall. So in the example on P.150, the investor is indifferent between receiving a cash dividend or share repurchase. If nothing were done at all, however, they would suffer from a decreased share price.
A lot of silly stuff posted on this topic. I think olivier was getting it closest. Economically (ignoring shareholder tax situation), there’s no difference between one-time dividend and share repurchase. Market cap drops by the amount distributed by the firm in either case. (If it doesn’t, there’s an obvious trade available.) For dividend, share price drops; for repo, share price stays the same but there are fewer outstanding shares. Other than the obvious economics, there are a number of other considerations that drive the decision between div and repo. In repo, number of shares drops, changing the control structure of the firm. Investors have the choice whether to take the cash (and tax hit) or ignore the repo. For this latter reason alone most firms will chose repo over one-time div. Dividend often “signals” improving financials at the firm, so you might see a bit of a share price bump. Also, if switching from no dividend to regular dividend, a new class of investor might be attracted and provide a price bump. (This may differ between IG and HY firms – most HY investors aren’t expecting a dividend and won’t pay more for it.) Of course if you cut a regular dividend you lose the bump(s) and sometimes a bit more. A final point made above is whether the cash is a surplus asset – i.e. if the firm makes less on cash investments than its cost of capital (which is generally the case for surplus cash). Like any surplus asset, surplus cash should be removed from the firm.
Here is another way to look at it: If a share was $20 before repurchase and remains the same after repurchase. Because of repurchase, outstanding shares have shrunk (30%) from 1000 shares to 700 shares. Now assume the company has been traditionally paying out dividends at a payout ratio of 50% of NetIncome. If NetIncome were $1000 (in the past and future), the old dividends were $1000*0.5/1000 = $0.5. After repurchase, the dividends become $1000*0.5/700=0.71. Surely you would think a share that will pay a dividend of .71 is more valuable than a share that pays $0.5 all else being the same.
Here’s a simple scenario. You have a holding company whose only asset is $1 million cash. It has no liabilities so book value = $1 million. Market cap = $1 million since no one would pay more or less for cash (an argument could be made to pay less for the cash, but we’ll ignore that for simplicity’s sake). There are 10,000 shares outstanding. $1,000,000 NBV / 10,000 shares = $100/share Now, let’s assume that $999,900 is used to repurchase 9,999 shares, leaving 1 share outstanding. The stock is now worth… $100 NBV / 1 share = $100/share No change.