While stock prices will most likely rise after a split or dividend (remember price increases are caused by positive signals a company generates with respect to future earnings), if positive news does not follow, the company's stock price will generally fall back to its original level.
There is an argument that stock splits and stock dividends are unnecessary and do little more than create more stocks.
In a stock split, a company will divide each share of its existing stock into multiple shares to bring down the company's stock price.
Suppose Newco's stock reaches $60 per share. The company's management believes this is too high and that some investors may not invest in the company as a result of the initial price required to buy the stock. As such, the company decides to split the stock to make the entry point of the shares more accessible.
For simplicity, suppose Newco initiates a 2-for-1 stock split. For each share they own, all holders of Newco stock therefore receive two Newco shares priced at $30, and the company's shares outstanding double. Keep in mind that the company's overall equity value remains the same. Say there are 1 million shares outstanding and the company's initial equity value is $60 million ($60 per share x 1 million shares outstanding). The equity value after the split is still $60 million ($30 per share x 2 million shares outstanding).
To learn more about stock splits, read: Understanding Stock Splits
Stock dividends are similar to cash dividends; however, instead of cash, a company pays out stock. As a result, a company's shares outstanding will increase, and the company's stock price will decrease. For example, suppose Newco decides to issue a 10% stock dividend. Each current stockholder will thus have 10% more shares after the dividend is issued.
A stock repurchase occurs when a company asks stockholders to tender their shares for repurchase by the company. This is an alternate way for a company to 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 the 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.
- From the perspective of an investor, a cash dividend is dependable, usually quarterly. 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.
- A company may be 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.
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 8 times earnings, Newco's new share price would be $42, an increase from the $40 per share before the repurchase.
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