Reading 39 of CFAI materials
Dividends and Share Repurchases: Basics
Intro
- Dividends and share repurchases are the two ways a company can distribute cash to its shareholders
- Dividends are not legally required and may be bound by other restrictive covenants
- Sometimes taxed at both corporate and shareholder level
- Dividends + shares repurchased = company's payout for the year
- Dividends can be an important source of return when stock prices are volatile
Forms of dividends
Regular
- Usually quarterly, semiannual, or annual
- Regular and especially increasing dividends signal to investor that company is growing and will share profits
- Automatically reinvests dividends into additional shares of the company
- Shareholders must indicate intent to participate
- Open Mkt DRP - company purchases shares in open mkt to give to plan participants
- New Issue DRP - issue new shares instead of repurchasing
- Some plans do both
- Can avoid flotation costs to issue new shares
- Allow for cost averaging and no transaction costs
- Note that nonparticipants will get diluted
- Disadvantage: changes cost basis for capital gains purposes - must keep records
- Also fully taxed in year granted - so might be best off in a 401k
- Can be used to get rid of excess cash
- Can also help moderate during a downturn - only pay out specials when things go well
- Company goes out of business and net assets are distributed to shareholders
- Sells portion of business for cash and distributes proceeds
- Pays a dividend that exceeds accumulated RE and thus impairs stated capital
- Non-cash form of dividend
- Issues typically 2-10% of then shares outstanding and issues to shareholders
- Total cost base remains same, but price per share decreases
- Generally not taxable - just divides the pie further
- Does not change fractional ownership or value of position - kind of a nothing move
- Increase in shares is perfectly offset by decrease in price
- Advantage: for company, it expands to a broader shareholder base; lower stock price attracts more investors
- Stock dividend has no effect on capital structure
- Cash dividends reduce assets (cash) and retained earnings/equity, thus affecting ratios
- Decreases liquidity and increases leverage
- Stock dividends DO reduce retained earnings but contributed capital rises by same amt
- Does not affect ratios
Stock Splits
- Assuming same P/E and dividend payout ratio, dividend yield (dividends/share price) is also unchanged
- Does not affect ratios
- 2:1 stock split is basically the same thing as a 100% stock dividend
- Difference in accounting treatment tho
- Stock dividend switched equity from RE to Cont Capital - Stock Split doesn't affect this
- Can announce at any time
- Not in and of itself a meaningful predictor of future price action
- Reverse Stock Splits
- Same but in reverse - intended to increase prices of shares
- Important for some institutional investors
- Declaration date - dividend is declared
- Also announce holder of record date and record and payment dates
- Ex-dividend date - usually 2 days before holder of record date
- This is the first date the shares trade without the dividend
- Signified in quotes with an x in the volume column that indicates the dividend value has been removed from share price
- Determined by exchange
- Holder of Record Date
- Two days before ex-dividend date
- Determined by corporation, not exchange
- Payment Date
- Can occur on a weekend or holiday
- Company actually mails out/send electronically the dividend
- Which ex and record date are always 2 days apart, the other timings can vary greatly
Share Repurchases
- Company buys back its own shares
- Alternative to cash dividends - uses company cash
- Repurchased shares are called treasury stock
- When an amount of share repurchases is authorized, it is not an obligation to repurchase
- Different than declaring a dividend, which is binding
- Motivators
- Signal to market that company thinks shares are undervalued or provide price support
- Flexibility - amount and timing are not perceived as a establishing an expectation of future actions
- Tax advantages - cash dividends might be taxed harder than capital gains
- Absorb increases in share dilution from exercise of employee stock options
- Maybe just has too much cash too
Share Repurchase Methods
- Buy in open market (most common)
- Maximum flexibility, no shareholder approval required (in US - in Europe, companies get preapprovale), no minimum commitment amount
- Buy back fixed number at fixed price
- Make a fixed price tender offer
- If oversubscribed, by a pro rata amount from each seller
- Dutch Auction
- Company states a range of acceptable prices
- Shareholder's bid up and then once you have met the stated amount with the qualifying bids you buy shares from all those who bid to that amount (e.g. $39 per share will get you 5 mm shares)
- Repurchase by Direct Negotiation
- Negotiate directly with large shareholders to buy back at a premium
- Prevent activist shareholding/large block overhang
- Sometimes takeover attempts end in target company buying suitor's shares back at a premium, to detriment of other shareholders ('greenmail transaction')
- Many transactions however are at discounts - driven by liquidity needs of large holders
Financial Statement Effects of Repurchases
- Can affect both balance sheet and IS
- A and E both decline if financed with cash
- Leverage will increase even more if repurchase is financed with debt
- Fewer shares out might increase EPS depending how and at what cost purchase is financed
- EPS
- May increase, stay, or decrease
- In case of internal financing, repurchase increases EPS ONLY IF funds used would NOT earn their cost of capital if retained by the company
- If externally financed (debt), improves EPS only if earnings yield (E/P) exceeds after tax cost of borrowing
- Book Value of Shares
- If shares on book are below market, book value per share decreases - you are buying cheaper shares in the market
- Reverse case is also true
- All other things equal, cash dividends and share repurchases in same amount should have same economic impact
- Negotiated share repurchases at a premium essentially transfer wealth from other shareholders to the beneficiary of the repurchase
End
1:15 pm
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