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.