Stock repurchase may be viewed as an alternative to paying dividends in that it is another method of returning cash to investors. A stock repurchase occurs when a company asks stockholders to tender their shares for repurchase by the company. There are several reasons why a stock repurchase can 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 that 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 an investor's perspective, a cash dividend is dependable; 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.
In addition, a company may find itself 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 eight times earnings, Newco's new share price would be $42, an increase from the $40 per share before the repurchase. (Read more about stock repurchases in Market News That Seems Promising But Isn't and Top Perks Warren Buffett Gets When Purchasing Equities.)
Stock Dividends And Stock Splits
InvestingLearn what a decline in share repurchases and dividend payouts by corporations means for equity markets, and whether it is a cause for long-term concern.
InvestingShare repurchases can have a significant positive impact on an investor’s portfolio and are a great way to build investor wealth over time.
InvestingWal-Mart announced huge internal investments along with an aggressive share repurchase program that isn't as good as it initially sounds.
InvestingA reverse repurchase agreement is the buyer side of a repurchase agreement (also called a repo).
MarketsAnalyze share repurchase data for the industrials sector to identify factors that are driving trends over time and buybacks by companies in the sector.
MarketsShare repurchases can impact investors and companies in different ways.
InvestingExamine historical buyback data from the financial sector to determine which quarters and companies contributed the most to repurchase activity.
MarketsA repurchase agreement is the equivalent of a short-term collateralized loan. An owner of marketable securities sells those securities to a buyer for cash. As part of the deal, the seller agrees ...
Personal FinanceAnalyze historical share repurchase data for the discretionary sector and identify the financial and economic factors that drive buybacks over time and by company.
MarketsExamine telecommunications sector share repurchase data to identify which companies and catalysts drove buyback trends between 2006 and 2015.