Complete Guide To Corporate Finance


Dividends - Stock Repurchase

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
Related Articles
  1. Professionals

    Career Advice: Accountant Vs. Financial Planner

    Identify the key differences between a career in accounting and financial planning, and learn how your personality dictates which is the better choice for you.
  2. Investing Basics

    What Does In Specie Mean?

    In specie describes the distribution of an asset in its physical form instead of cash.
  3. Economics

    Calculating Days Working Capital

    A company’s days working capital ratio shows how many days it takes to convert working capital into revenue.
  4. Economics

    Calculating Cross Elasticity of Demand

    Cross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
  5. Fundamental Analysis

    Emerging Markets: Analyzing Colombia's GDP

    With a backdrop of armed rebels and drug cartels, the journey for the Colombian economy has been anything but easy.
  6. Professionals

    Career Advice: Accountant Vs. Controller

    Learn about the differences between controllers and accountants, how the two are related and which is the best career choice for aspiring bookkeepers.
  7. Professionals

    What is Cash Basis Accounting?

    Cash basis accounting recognizes revenues and expenses at the time cash is paid or received.
  8. Entrepreneurship

    What's a Good Profit Margin for a Mature Business?

    How to determine if the amount you clear dovetails with the competition.
  9. Fundamental Analysis

    Emerging Markets: Analyzing Chile's GDP

    Chile has become one of the great economic success stories of Latin America.
  10. Investing

    Watch Your Duration When Rates Rise

    While recent market volatility is leading investors to look for the nearest exit, here are some suggestions for bond exposure in attractive sectors.
  1. Put-Call Parity

    A principle that defines the relationship between the price of ...
  2. Encumbrance

    A claim against a property by a party that is not the owner. ...
  3. Alpha

    Alpha is used in finance to represent two things: 1. a measure ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based ...
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  6. Linear Relationship

    A statistical term used to describe the directly proportional ...
  1. What should I study in school to prepare for a career in corporate finance?

    Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >>
  2. Why would a company issue preference shares instead of common shares?

    Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >>
  3. What is the difference between cost of debt capital and cost of equity?

    In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >>
  4. What is the difference between gross profit, operating profit and net income?

    The terms profit and income are often used interchangeably in day-to-day life. In corporate finance, however, these terms ... Read Full Answer >>
  5. Does working capital include salaries?

    A company accrues unpaid salaries on its balance sheet as part of accounts payable, which is a current liability account, ... Read Full Answer >>
  6. Student loans, federal and private: what's the difference?

    The cost of a college education now rivals many home prices, making student loans a huge debt that many young people face ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  3. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  4. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  5. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  6. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!