Corporate Finance - Stock Dividends and Repurchases

Like cash dividends, stock dividends and stock splits also have effects on a company's stock price. Stock splits occur when a company perceives that its stock price may be too high. Companies tend to want to keep their stock price within an optimal trading range.

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.

Stock Split
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.

Example:
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
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.

Stock Repurchase
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.
 
Disadvantage of a Stock Repurchase
  • 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.
     
Price Effect of a Stock Repurchase
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.

Introduction


Related Articles
  1. Stock Analysis

    Retailers Buying Back Stock

    American companies have announced $258 billion in share repurchase plans so far this year. Find out which retail companies are buying.
  2. Investing Basics

    What Are Corporate Actions?

    Corporate actions are processes that change a company’s stock. Here are a few examples.
  3. Stock Analysis

    Special Dividends Trump Share Repurchases Every Time

    Let's look at share repurchases to demonstrate why special dividends are far superior to buybacks.
  4. Investing Basics

    How To Profit From Stock Splits And Buybacks

    If stock splits and buybacks have been a bit of a mystery to you, you're not alone. Learn some great tips.
  5. Stock Analysis

    Companies With Profitable Stock Buybacks

    We look at five apparel companies and how well they've done buying back shares. Not all are created equal.
  6. Stock Analysis

    Companies Whipping Out Wallets To Buy Back Stock

    While a stock repurchase is no guarantee that a stock will increase in value, it may be a good sign that better times are ahead.
  7. Active Trading

    Don't Let Stock Prices Fool You

    Find out why a stock with a six-figure share price can still be a good value.
  8. Investing

    Wal-Mart's Share Repurchase Isn't All Good

    Wal-Mart announced huge internal investments along with an aggressive share repurchase program that isn't as good as it initially sounds.
  9. Stock Analysis

    The Best Capital Allocator In Consumer Goods

    These six stocks were chosen as favorites in the consumer goods field for 2010. Do they live up to the hype?
  10. Investing Basics

    Stock Buyback/Repurchase

    A stock buyback, or repurchase, occurs when a company buys its own shares off the market and therefore reduces the amount of stock outstanding.
RELATED TERMS
  1. Outstanding Shares

    A company's stock currently held by all its shareholders, including ...
  2. Normal-Course Issuer Bid - NCIB

    A Canadian term for a company repurchasing its own stock from ...
  3. Rule 10b-18

    An SEC rule that provides a "safe harbor" for companies and their ...
  4. Dividend

    A distribution of a portion of a company's earnings, decided ...
  5. Indicated Yield

    The dividend yield that a share of stock would return based on ...
  6. Reverse Stock Split

    A corporate action in which a company reduces the total number ...
RELATED FAQS
  1. Why would a company choose to repurchase in lieu of redeem?

    Learn the difference between a stock repurchase and a stock redemption, and find out about the reasons why a company might ... Read Answer >>
  2. Does a stock dividend dilute the price per share as would a forward stock split?

    Every corporation has the same goal in mind: to maximize shareholder wealth. This goal is fulfilled in two different ways, ... Read Answer >>
  3. Why should a company buy back shares it feels are undervalued instead of redeeming ...

    Discover the difference between common stock and preferred stock. When is repurchase preferable to redemption, and what factors ... Read Answer >>
  4. How does it affect a company's credit rating to buy back shares?

    Learn how buying back shares can negatively affect a company's credit rating if the company uses debt to finance a share ... Read Answer >>
  5. What happens to the value of a mutual fund when a stock splits?

    Find out what happens to the value of a mutual fund when a stock in its portfolio splits, including how stock splits work ... Read Answer >>
  6. What are reverse stock splits?

    A reverse stock split is a corporate action in which a company reduces the number of shares it has outstanding by a set multiple. ... Read Answer >>
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center