Stock Buyback [Repurchase]: Cash Returned to Stock Holders

Companies return cash to stockholders in the form of dividends, but over the last few years, they have also increasingly turned to stock buybacks as an alternative. In this post, I discuss cash returned to stock holders which focus on stock buybacks:  the effects of buying back stock, the magnitude of stock buybacks, reasons for stock buybacks [the potential benefit of stock buyback], and choosing between dividends and equity repurchases. To enrich this post, I also provide two practical overview and tips you may find them useful: “how to buy back stocks” and “equity repurchase and the dilution illusion”. Enjoy!

Firms  in  the  United  States  have  turned  increasingly  to  buying back stock to either augment regular dividends, or, in some cases, to substitute for  cash dividends.  Until the middle of the  1980s, dividends  remained  the  primary mechanism  for  firms  to  return  cash  to  stockholders.  Starting in that period, firms increasingly turn to buying back their own stock, using either cash on hand or borrowed money, as a mechanism for returning cash to their stockholders.

The Effects of Buying Back Stock

Let us first consider the effect of a stock buyback on the firm doing the buyback. The stock buyback requires cash, just as a dividend would, and thus has the same effect on the assets of the firm – a reduction in the cash balance. Just as a dividend reduces the book value of the equity in the firm, a stock buyback reduces the book value of equity.

Thus,  if  a  firm with  a  book  value  of  equity  of  $  1  billion  buys  back  $  400 million in equity, the book value of equity will drop to $ 600 million. Both a dividend payment and a stock buyback reduce the overall market value of equity in the firm, but the way they affect the market value is different. The  dividend  reduces  the market  price,  on  the  ex-dividend  day  and  does  not  change  the  number  of  shares  outstanding. A  stock  buyback reduces  the  number  of  shares  outstanding  and  is  often  accompanied  by  a  stock  price increase. For instance, if a firm with 100 million shares outstanding trading at $ 10 per share buys back 10 million shares, the number of shares will decline to 90 million, but the stock price may increase to $ 10.50. The total market value of equity after the buyback will be $ 945 million, a drop in value of 5.5%.

Unlike  a  dividend,  which  returns  cash  to  all  stockholders  in  a  firm,  a  stock buyback  returns cash  selectively  to  those stockholders who choose  to  sell  their stock to the  firm. The  remaining  stockholders  get  no  cash;  they  gain  indirectly  from  the  stock buyback  if  the stock price  increases. Stockholders in the firm described above will find the value of their holdings increasing by 5%, after the stock buyback.

Practice Insight: How to Buy Back Stocks

The process of repurchasing equity [buyback stock is in this case] will depend  largely  upon whether  the  firm intends to repurchase stock in the open market, at the prevailing market price, or to make a more  formal  tender  offer  for  its  shares.

There are three widely used approaches to buying back equity:
 
Repurchase Tender Offers – In  a  repurchase  tender  offer,  a  firm  specifies  a  price  at  which  it will buy back shares,  the number of shares  it  intends  to repurchase, and  the period  of  time  for  which  it  will  keep  the  offer  open,  and  invites  stockholders  to submit  their  shares  for  the  repurchase.  In many cases,  firms  retain  the  flexibility  to withdraw  the offer  if an  insufficient number of shares are submitted or  to extend  the offer beyond the originally specified time period. This approach is used primarily for large equity repurchases.
 
Open Market Purchases – In the case of open market repurchases, firms buy shares in the  market  at  the  prevailing  market  price.  While  firms  do  not  have  to  disclose publicly their intent to buy back shares in the market, they have to comply with SEC requirements  to  prevent  price manipulation  or  insider  trading. Finally, open market purchases can be spread out over much longer time periods than tender offers and are much more widely used for smaller repurchases.  In terms of flexibility, an open market repurchase affords the firm much more freedom in deciding when to buy back shares and how many shares to repurchase.

Privately Negotiated  Repurchases –  In  privately  negotiated  repurchases,  firms  buy back  shares  from  a  large  stockholder  in  the  company  at  a  negotiated  price.  This method  is not as widely used as  the  first  two and may be employed by managers or owners as a way of consolidating control and eliminating a troublesome stockholder.

The Magnitude of Stock Buybacks

In  the  last  decade,  more  and  more  firms  have  used  equity  repurchases  as  an alternative  to  paying  dividends. It  is worth noting  that while aggregate dividends at all US firms have grown at a rate of about 1.18% a year over this 10-year period, stock buybacks have grown 9.83% a year.

This shift has been much less dramatic outside the United States. Firms  in other countries  are  far  less  likely  to  use  stock  buybacks  to  return  cash  to  stockholders  for  a number of reasons:

• First, dividends in the United States bear a much higher tax burden, relative to capital gains, than dividends paid in other countries. Many European countries, for instance, allow investors to claim a tax credit on dividends, for taxes paid by the firms paying these dividends. Stock buybacks, therefore, provide a much greater tax benefit to investors  in  the  United  States  than  they  do  to  investors  outside  the United  States,  by shifting income from dividends to capital gains.
• Second, stock buybacks are prohibited or tightly constrained in many countries.
• Third,  a  strong  reason  for  the  increase  in  stock buybacks  in  the United States has been pressure  from stockholders on managers  to pay out  idle cash. This pressure is far less in the weaker corporate governance systems that exist outside the United States.

Reasons for Stock Buybacks

Firms  that want  to  return  substantial  amounts  of  cash  to  their  stockholders  can either  pay  a  large  special  dividend  or  buy  back  stock. There are several advantages to both the firm and  its stockholders  to using stock buybacks as an alternative  to dividend payments.

There are four significant advantages to the firm:

• Unlike  regular  dividends, which  typically  commit  the  firm  to  continue  payment  in future periods, equity  repurchases are one-time  returns of cash. Consequently,  firms with  excess  cash  that  are  uncertain  about  their  ability  to  continue  generating  these cash  flows  in  future  periods  should  repurchase  stocks  rather  than  pay  dividends. (They could also choose to pay special dividends, since these do not commit the firm to making similar payments in the future.)
• The decision to repurchase stock affords a firm much more flexibility to reverse itself and  to  spread  the  repurchases  over  a  longer  period  than  does  a  decision  to  pay  an equivalent special dividend. In fact, there is substantial evidence that many firms that announce  ambitious  stock  repurchases  do  reverse  themselves  and  do  not  carry  the plans through to completion.
• Equity  repurchases may  provide  a way  of  increasing  insider  control  in  firms,  since they  reduce  the  number  of  shares  outstanding.  If  the  insiders  do  not  tender  their shares  back,  they  will  end  up  holding  a  larger  proportion  of  the  firm  and, consequently, having greater control.
• Finally, equity  repurchases may provide  firms with a way of  supporting  their  stock prices, when  they are declining. For instance, in the aftermath of the crash of 1987, many firms initiated stock buyback plans to keep stock prices from falling further.

There are two potential benefits that stockholders might perceive in stock buybacks:

• Equity  repurchases  may  offer  tax  advantages  to  stockholders,  since  dividends  are
  taxed  at  ordinary  tax  rates,  while  the  price  appreciation  that  results  from  equity repurchases is taxed at capital gains rates. Furthermore, stockholders have the option not to sell their shares back to the firm and therefore do not have to realize the capital gains in the period of the equity repurchases.
• Equity repurchases are much more selective in terms of paying out cash only to those stockholders  who  need  it.  This  benefit  flows  from  the  voluntary  nature  of  stock buybacks:  those who  need  the  cash  can  tender  their  shares  back  to  the  firm, while those who do not can continue to hold on to them. In  summary,  equity  repurchases  allow  firms  to  return  cash  to  stockholders  and  still maintain flexibility for future periods.

Intuitively, we would expect stock prices to increase when companies announce that they will be buying back stock. Studies have looked at the effect on stock price of the announcement that a firm plans to buy back stock. There is strong evidence that stock prices increase in response.

Practical Insight: Equity Repurchase and the Dilution Illusion

Some  equity  repurchases  are motivated  by  the  desire  to  reduce  the  number  of shares outstanding and  therefore  increase  the earnings per  share.  If we  assume  that  the firm’s  price  earnings  ratio will  remain  unchanged,  reducing  the  number  of  shares will usually  lead  to  a  higher  price.  This provides a simple rationale for many companies embarking on equity repurchases.

There is a problem with this reasoning, however. Although  the  reduction  in  the number  of  shares might  increase  earnings  per  share,  the  increase  is  usually  caused  by higher debt ratios and not by the stock buyback perse. In other words, a special dividend of  the  same  amount  would  have  resulted  in  the  same  returns  to  stockholders.

Furthermore,  the  increase  in  debt  ratios  should  increase  the  riskiness  of  the  stock  and lower  the  price  earnings  ratio. Whether  a  stock  buyback will  increase  or  decrease  the price  per  share will  depend  on whether  the  firm  is moving  to  its  optimal  debt  ratio  by repurchasing  stock,  in which  case  the  price will  increase,  or moving  away  from  it,  in which case the price will drop.

To  illustrate,  assume  that  an  all-equity  financed  firm  in  the  specialty  retailing business,  with  100  shares  outstanding,  has  $100  in  earnings  after  taxes  and  a market value of $1,500. Assume that this firm borrows $300 and uses the proceeds to buy back 20 shares. As long as the after-tax interest expense on the borrowing is less than $ 20, this firm will report higher earnings per share after the repurchase.  If the firm’s tax rate is 50%, for instance, the effect on earnings per share is summarized in the table below for two scenarios: one where the interest expense is $ 30 and one where the interest expense If we assume that the price earnings ratio remains at 15, the price per share will change in proportion to the earnings per share.

Realistically, however, we should expect to see a drop in the price  earnings  ratio,  as  the  increase  in  debt makes  the  equity  in  the  firm riskier. Whether the drop will be sufficient  to offset or outweigh an  increase  in earnings per  share will depend upon whether  the  firm has excess debt capacity and whether, by going to 20%, it is moving closer to its optimal debt ratio.

Choosing between Dividends and Equity Repurchases

Firms that plan to return cash to their stockholders can either pay them dividends or buy back stock. How do they choose? 

The choice will depend upon the following factors:

Sustainability  and  Stability  of  Excess  Cash  Flow –  Both  equity  repurchases  and increased  dividends  are  triggered  by  a  firm’s  excess  cash  flows.  If the excess cash flows are temporary or unstable, firms should repurchase stock; if they are stable and predictable, paying dividends provides a stronger signal of future project quality.

Stockholder  Tax  Preferences –  If  stockholders  are  taxed  at  much  higher  rates  on dividends  than capital gains,  they will be better off  if  the firm  repurchases stock.  If, on  the  other  hand,  stockholders  prefer  dividends,  they will  gain  if  the  firm  pays  a special dividend.

Predictability  of  Future  Investment  Needs –  Firms  that  are  uncertain  about  the magnitude of future investment opportunities should use equity repurchases as a way of returning cash to stockholders. The flexibility that is gained will be useful, if they need cash flows in a future period to accept an attractive new investment.

Undervaluation of the Stock – For two reasons, an equity repurchase makes even more sense when managers believe their stock to be undervalued. First, if the stock remains undervalued, the remaining stockholders will benefit if managers buy back stock at less than true value. The difference between the true value and the market price paid on the buyback will be accrued to those stockholders who do not sell their stock back. Second,  the  stock  buyback may  send  a  signal to financial markets  that  the  stock  is undervalued, and the market may react accordingly, by pushing up the price. 

Management  Compensation –  Managers often  receive  options  on  the  stock  of  the companies  that  they manage.  The prevalence and magnitude of such option-based compensation can affect whether firms use dividends or buy back stock. The payment of dividends reduces stock prices, while leaving the number of shares unchanged. The buying  back  of  stock  reduces  the  number  of  shares,  and  the  share  price  usually increases  on  the  buyback.  Since options become less valuable as the stock price decreases, and more valuable as the stock price increases, managers with significant option positions may be more likely to buy back stock than pay dividends.

While  the  option  holdings  of  managers  seemed  to  have  had  no  statistical  impact  on whether  firms  bought  back  stock  or  increased  dividends,  firms  buying  back  stock  had higher  book  to  market  ratios  than  firms  increasing  dividends,  and  more  institutional stockholders. The  higher  book  to  price  ratio  can  be  viewed  as  an  indication  that  these firms are more likely to view themselves as under- valued. The larger institutional holding might suggest a greater sensitivity to the tax advantage of stock buybacks.