Question

Explain Dividend and Share buyback policy Theory in detail. Please also provide relevant examples of such.

Answer 1

A dividend is the share of profits that is distributed to shareholders in the company and the return that shareholders receive for their investment in the company. The company’s management must use the profits to satisfy its various stakeholders, but equity shareholders are given first preference as they face the highest amount of risk in the company.

A dividend policy is the policy a company uses to structure its dividend payout to shareholders. Some researchers suggest the dividend policy is irrelevant, in theory, because investors can sell a portion of their shares or portfolio if they need funds. This is the dividend irrelevance theory, which infers that dividend payouts minimally affect a stock's price. There are three types of dividend policies—a stable dividend policy, a constant dividend policy, and a residual dividend policy.

Stable Dividend Policy

A stable dividend policy is the easiest and most commonly used. The goal of the policy is a steady and predictable dividend payout each year, which is what most investors seek. Whether earnings are up or down, investors receive a dividend.

The goal is to align the dividend policy with the long-term growth of the company rather than with quarterly earnings volatility. This approach gives the shareholder more certainty concerning the amount and timing of the dividend.

Constant Dividend Policy

The primary drawback of the stable dividend policy is that investors may not see a dividend increase in boom years. Under the constant dividend policy, a company pays a percentage of its earnings as dividends every year. In this way, investors experience the full volatility of company earnings.

If earnings are up, investors get a larger dividend; if earnings are down, investors may not receive a dividend. The primary drawback to the method is the volatility of earnings and dividends. It is difficult to plan financially when dividend income is highly volatile.

Residual Dividend Policy

Residual dividend policy is also highly volatile, but some investors see it as the only acceptable dividend policy. With a residual dividend policy, the company pays out what dividends remain after the company has paid for capital expenditures (CAPEX) and working capital.

This approach is volatile, but it makes the most sense in terms of business operations. Investors do not want to invest in a company that justifies its increased debt with the need to pay dividends.

Example of a Dividend Policy

Kinder Morgan (KMI) shocked the investment world when in 2015 they cut their dividend payout by 75%, a move that saw their share price tank. However, many investors found the company on solid footing and making sound financial decisions for their future. In this case, a company cutting their dividend actually worked in their favor, and six months after the cut, Kinder Morgan saw its share price rise almost 25%. In early 2019, the company again raised its dividend payout by 25%, a move that helped to reinvigorate investor confidence in the energy company.

Share Buyback Policy

A share repurchase also known as share buyback is a transaction whereby a company buys back its own shares from the marketplace. A company might buy back its shares because management considers them undervalued. The company buys shares directly from the market or offers its shareholders the option of tendering their shares directly to the company at a fixed price.

This act reduces the number of outstanding shares, which increases both the demand for the shares and the price.

What Happens After a Share Repurchase

Because a share repurchase reduces the number of shares outstanding, it increases earnings per share (EPS). A higher EPS elevates the market value of the remaining shares. After repurchase, the shares are canceled or held as treasury shares, so they are no longer held publicly and are not outstanding.

Reasons for a Share Repurchase

A share repurchase reduces the total assets of the business so that its return on assets, return on equity and other metrics improve when compared to not repurchasing shares. Reducing the number of shares means earnings per share (EPS), revenue and cash flow grow more quickly.

If the business pays out the same amount of total money to shareholders annually in dividends and the total number of shares decreases, each shareholder receives a larger annual dividend. If the corporation grows its earnings and its total dividend payout, decreasing the total number of shares further increases the dividend growth. Shareholders expect a corporation paying regular dividends will continue doing so.

In some cases, a buyback can hide a slightly declining net income. If the share repurchase reduces the shares outstanding to a greater extent than the fall in net income, the EPS will rise irrespective of the financial state of the business.

Benefits of a Share Repurchase

A share repurchase shows that the corporation believes its shares are undervalued and is an efficient method of putting money back in shareholders’ pockets. The share repurchase reduces the number of existing shares, making each worth a greater percentage of the corporation. The stock’s EPS increases while the price-to-earnings ratio (P/E) decreases or the stock price increases. A share repurchase demonstrates to investors that the business has sufficient cash set aside for emergencies and a low probability of economic troubles.

Drawbacks of a Share Repurchase

Criticism of buybacks is that they are often ill-timed. A company will buy back shares when it has plenty of cash or during a period of financial health for the company and the stock market. The stock price of a company is likely to be high at such times, and the price might drop after a buyback. A drop in the stock price can imply that the company is not so healthy after all.

Also, a share repurchase can give investors the impression that the corporation does not have other profitable opportunities for growth, which is an issue for growth investors looking for revenue and profit increases. A corporation is not obligated to repurchase shares due to changes in the marketplace or economy. Repurchasing shares puts a business in a precarious situation if the economy takes a downturn or the corporation faces financial obligations that it cannot meet.

Also, a share repurchase can give investors the impression that the corporation does not have other profitable opportunities for growth, which is an issue for growth investors looking for revenue and profit increases. A corporation is not obligated to repurchase shares due to changes in the marketplace or economy. Repurchasing shares puts a business in a precarious situation if the economy takes a downturn or the corporation faces financial obligations that it cannot meet.