In: Finance
Think about the non-tax-related differences between share repurchases and dividends. Describe the firms in which each difference would be relatively more important
Stock repurchase may be viewed as an alternative to paying
dividends in that it is another method of returning cash to
investors. A stock repurchase occurs when a company asks
stockholders to tender their shares for repurchase by the company.
There are several reasons why a stock repurchase can increase value
for stockholders. First, a repurchase can be used to restructure
the company's capital structure without increasing the company's
debt load. Additionally, rather than a company changing its
dividend policy, it can offer value to its stockholders through
stock repurchases, keeping in mind that capital gains taxes are
lower than taxes on dividends.
Advantages of a Stock Repurchase
Many companies initiate a share repurchase at a price level that
management deems a good entry point. This point tends to be when
the stock is estimated to be undervalued. If a company knows its
business and relative stock price well, would it purchase its stock
price at a high level? The answer is no, leading investors to
believe that management perceives its stock price to be at a low
level.
Unlike a cash dividend, a stock repurchase gives the decision to
the investor. A stockholder can choose to tender his shares for
repurchase, accept the payment and pay the taxes. With a cash
dividend, a stockholder has no choice but to accept the dividend
and pay the taxes.
At times, there may be a block of shares from one or more large
shareholders that could come into the market, but the timing may be
unknown. This problem may actually keep potential stockholders away
since they may be worried about a flood of shares coming onto the
market and lessening the stock's value. A stock repurchase can be
quite useful in this situation.
Disadvantage of a Stock Repurchase
From an investor's perspective, a cash dividend is dependable; a
stock repurchase, however, is not. For some investors, the
dependability of the dividend may be more important. As such,
investors may invest more heavily in a stock with a dependable
dividend than in a stock with less dependable repurchases.
In addition, a company may find itself in a position where it ends
up paying too much for the stock it repurchases. For example, say a
company repurchases its shares for $30 per share on June 1. On June
10, a major hurricane damages the company's primary operations. The
company's stock therefore drops down to $20. Thus, the
$10-per-share difference is a lost opportunity to the
company.
Overall, stockholders who offer their shares for repurchase may be
at a disadvantage if they are not fully aware of all the details.
As such, an investor may file a lawsuit with the company, which is
seen as a risk.
Price Effect of a Stock Repurchase
A stock repurchase typically has the effect of increasing the price
of a stock.
Example: Newco has 20,000 shares outstanding and a net income of
$100,000. The current stock price is $40. What effect does a 5%
stock repurchase have on the price per share of Newco's
stock?
Answer: To keep it simple, price-per-earnings ratio (P/E) is the
valuation metric used to value Newco's price per share.
Newco's current EPS = $100,000/20,000 = $5 per share
P/E ratio = $40/$5 = 8x
With a 2% stock repurchase, the following occurs:
Newco's shares outstanding are reduced to 19,000 shares (20,000 x
(1-.05))
Newco's EPS = $100,000/19,000 = $5.26
Given that Newco's shares trade on eight times earnings, Newco's
new share price would be $42, an increase from the $40 per share
before the repurchase.
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