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. Investing

    Behind U.S. Equities' Declining Buybacks and Dividend Payments

    Learn 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.
  2. Investing

    Impact of Share Repurchases

    Share repurchases can have a significant positive impact on an investor’s portfolio and are a great way to build investor wealth over time.
  3. 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.
  4. Investing

    The Impact Of Share Repurchases

    Share repurchases can impact investors and companies in different ways.
  5. Insurance

    The Share Buyback Report: The Financial Sector

    Examine historical buyback data from the financial sector to determine which quarters and companies contributed the most to repurchase activity.
  6. Investing

    Repurchase Agreement

    A 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 ...
  7. Investing

    What's Your Stock's Repurchase Premium?

    Take a closer look at your favorite stock's statement of equity; you never know what you're going to find
  8. Investing

    The Share Buyback Report: The Telecom Sector (T, VZ)

    Examine telecommunications sector share repurchase data to identify which companies and catalysts drove buyback trends between 2006 and 2015.
  9. Investing

    The Share Buyback Report: The Energy Sector (XOM, CVX)

    Examine historical share repurchase data for the energy sector. Review buyback activity over time, and find out which companies return the most capital to shareholders.
  10. Investing

    Are Share Buybacks Propping Up the Market? (AAPL, MSFT)

    Companies are repurchasing their own shares at a rate not seen in nearly a decade, prompting observers to fret that demand for equities is not as strong as the past six weeks' rally would suggest.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center