Stock Buybacks

Stable Dividend Policy

The stable dividend policy focuses on a steady dividend payout, even though earnings may be volatile from year to year. Companies that use a stable dividend policy typically look at a forecast of their long run earnings to determine the appropriate level for the stable dividend. This typically means aligning the company’s dividend growth rate with the company’s long term earnings growth rate.

A stable dividend policy could be gradually moving towards a target dividend payout ratio. A model of gradual adjustment is called a target payout adjustment model.

Target Payout Adjustment Model

If company earnings are expected to increase and the current payout ratio is below the target payout ratio, an investor can estimate future dividends through the following formula:

Worked example: Expected dividend based on a target payout adjustment approach

Last year, Buckeye, Inc., had earnings of $3.50 per share and paid a dividend of $0.70. In the current year, the company expects to earn $4.50 per share. The company has a 35% target payout ratio and plans to bring its dividend up to the target payout ratio over a 5 year period.

Calculate the expected dividend for the current year using the target payout adjustment model.

Solution

Constant Dividend Payout Ratio Policy

A payout ratio is the percentage of total earnings paid out as dividends. The constant payout ratio represents the proportion of earnings that a company plans to pay out to shareholders. A strict interpretation of the constant payout ratio method means that a company would pay out a specific percentage of its earnings each year as dividends, and the amount of those dividends would vary directly with earnings.

This practice is seldom used.

Dividend policy has been seen to have differences across countries and over time. This is probably to accommodate differences in investor preferences globally as well as changing investor preferences over time. The following generalizations can be made with respect to global trends in corporate payout policies:

1. Globally, in developed markets, the proportion of companies paying cash dividends has trended downwards over the long term.

2. The percentage of companies making stock repurchases has been trending upwards in the United States since the 1980s and in the United Kingdom and continental Europe since the 1990s. Major companies in Asia (particularly China (中国) and Japan (日本)) have made substantial repurchases since the 2010s.

Four common methods are used for share buybacks, though due to varying rules, some markets may not allow all methods. Outside the United States and Canada, method 1 is used almost exclusively.

1. Open market transactions are the most flexible approach, allowing a company to buy back its shares in the open market at the most favorable terms. There is no obligation on the part of the company to complete an announced buyback program. Unlike their European counterparts, American companies do not need shareholder approval for open market transactions.

2. Fixed price tender offer is an approach where the firm buys a predetermined number of shares at a fixed price, typically at a premium over the current market price. Although the company forgoes flexibility (the firm cannot execute its purchases at an exact opportune time), it allows a company to buy back its shares rather quickly. If more than the desired number of shares are tendered in response to the offer, the company will typically buy back a prorated number of shares from each shareholder responding to the offer.

3. Dutch auction is a tender offer in which the company specifies not a single fixed price but rather a range of prices. Dutch auctions identify the minimum clearing price for the desired number of shares that need to be repurchased. Each participating shareholder indicates the price and the number of shares tendered.

Bids are accepted based on lowest price first until the desired quantity is filled. The price of the last offer accepted (i.e., the highest accepted bid price) will be the price paid for all shares tendered. Hence, a shareholder can increase the chance of having their tender accepted by offering shares at a low price.

Dutch auctions can be accomplished rather quickly, though not as quickly as tender offers.

4. Repurchase by direct negotiation entails purchasing shares from a major shareholder, often at a premium over market price. This method is often used in a greenmail scenario (where a hostile bidder is offered a premium to go away) to the detriment of the remaining shareholders. A negotiated purchase can also occur when a company wants to remove a large overhang in the market that is dampening the share price.

Surprisingly, many negotiated transactions occur at a discount to market price, indicating that urgent liquidity needs of the seller motivated the transaction.

Repurchases made using a company’s surplus cash will lower cash and shareholders’ equity and, therefore, increase the firm’s leverage (i.e., the debt to asset and debt to equity ratios). After the repurchase, earnings per share may increase (depending on the amount of cash used) because there will be fewer shares outstanding. If the repurchase was financed with additional debt offerings, the reduction in net income from the (after tax) cost of the borrowed funds must also be factored in to determine the new impact on earnings per share.

After a stock repurchase, the number of outstanding shares will decrease and the book value per share (BVPS) is likely to change as well. If the price paid is higher (lower) than the pre repurchase BVPS, the BVPS will decrease (increase).

Worked example: Impact of share repurchase on book value per share

Consider two companies, Alpha and Beta, which are both considering the repurchase of $5 million worth of shares. Additional details are given in the following:

	Alpha	Beta
Stock price	$20	$20
Number of shares outstanding	1 million	2 million
Book value	$15 million	$25 million

Calculate the impact of the repurchase transactions on BVPS.

Solution

Alpha’s BVPS of $15.00 was less than the $20.00 stock price, so after the buyback, Alpha’s BVPS decreased to $13.33. Beta’s BVPS increased from $25.00 to $26.67 after the buyback because the BVPS was greater than the $20.00 stock price.

There are five common rationales for share repurchases (versus dividends):

1. Potential tax advantages. When the tax rate on capital gains is lower than the tax rate on dividend income, share repurchases have a tax advantage over cash dividends.

2. Share price support/signaling. Companies may purchase their own stock, thereby signaling to the market that the company views its own stock as a good investment. Signaling is important in the presence of asymmetric information (where corporate insiders have access to better information about the company’s prospects than outside investors). Management can send a signal to investors that the future outlook for the company is good.

This tactic is often used when a share price is declining and management wants to convey confidence in the company’s future to investors.

3. Added flexibility. A company could declare a regular cash dividend and periodically repurchase shares as a supplement to the dividend. Unlike dividends, share repurchases are not a long term commitment. Since paying a cash dividend and repurchasing shares are economically equivalent, a company could declare a small stable dividend and then repurchase shares with the company’s leftover earnings.

Additionally, managers have discretion with respect to “market timing” their repurchases.

4. Offsetting dilution from employee stock options. Repurchases offset EPS dilution that results from the exercise of employee stock options.

5. Increasing financial leverage. When funded by new debt, share repurchases increase leverage. Management can change the company’s capital structure (and perhaps move toward the company’s optimal capital structure) by decreasing the percentage of equity.

Worked example: Share repurchase when the after tax cost of debt is less than the earnings yield

Spencer Pharmaceuticals, Inc., (SPI) plans to borrow $30 million that it will use to repurchase shares. SPI’s chief financial officer has compiled the following information:

Share price at the time of buyback = $50.

Shares outstanding before buyback = 20,000,000. EPS before buyback = $5.00.

Earnings yield = $5.00 / $50 = 10%. After tax cost of borrowing = 8%. Planned buyback = 600,000 shares.

Calculate the EPS after the buyback.

Solution

Since the after tax cost of borrowing of 8% is less than the 10% earnings yield (E/P) of the shares, the share repurchase will increase the company’s EPS.

Worked example: Share repurchase with borrowed funds, where the after tax cost of debt exceeds the earnings yield

Spencer Pharmaceuticals, Inc., (SPI) plans to borrow $30 million that it will use to repurchase shares; however, creditors perceive the company to be a significant credit risk, and the after tax cost of borrowing has jumped to 15%. Using the other information from the previous example, calculate the EPS after the buyback.

Solution

Because the after tax cost of borrowing of 15% exceeds the earnings yield of 10%, the added interest paid reduces earnings, and the EPS after the buyback is less than the original $5.00.

The conclusion is that a share repurchase using borrowed funds will increase EPS if the after tax cost of debt used to buy back shares is less than the earnings yield of the shares before the repurchase. It will decrease EPS if the cost of debt is greater than the earnings yield, and it will not change EPS if the two are equal.

Dividend safety is the metric used to evaluate the probability of dividends continuing at the current rate for a company. Traditional ratios, such as dividend payout ratio (dividends/net income) or its inverse dividend coverage ratio (net income/dividends), are typically used for this purpose. A higher than normal dividend payout ratio (and lower than normal dividend coverage ratio) tends to typically indicate a higher probability of a dividend cut (or a lower probability of dividend sustainability).

In analyzing these ratios, we should compare the computed ratio to the average ratio for the industry and market within which a company operates. In making a qualitative judgment about a company, stable or increasing dividends are looked upon favorably, whereas companies that have cut their dividends in the past are looked upon unfavorably.

Another ratio considers free cash flow to equity (FCFE). FCFE is the cash flow available for distribution to stockholders after working capital and fixed capital needs are accounted for.

Note that unlike the dividend payout ratio, the FCFE coverage ratio considers not only dividends but also share repurchases.

A FCFE coverage ratio significantly less than one is considered unsustainable. In such a situation, the company is drawing down its cash reserves for dividends and repurchases.

Worked example: Dividend sustainability analysis

Chevron Corp. (NYSE: CVX) is a San Ramon, CA based global integrated energy company. Selected financial data for the years ending December 31, 2008 and 2009 is provided.

1. Using the information provided, calculate:

A. Dividend payout ratio.

B. Dividend coverage ratio.

C. FCFE coverage ratio.

2. Discuss the trend in dividend coverage ratio and compare it to FCFE coverage ratio.

3. Is Chevron’s dividend sustainable?

Solution

1. a. Dividend payout ratio = dividend / net income. 2008: 5,261 / 23,931 = 0.22 or 22% 2009: 5,373 / 10,483 = 0.51 or 51% b.

Dividend coverage ratio = net income / dividend

2008: 23,931 / 5,261 = 4.55 2009: 10,483 / 5,373 = 1.95

c. FCFE = cash flow from operations − FCInv + net borrowings

2008: FCFE = 29,632 − 19,666 + 1,682 = 11,648 2009: FCFE = 19,373 − 19,843 + 1,659 = 1,189 FCFE coverage ratio = FCFE / (dividends + share repurchases) FCFE coverage ratio:

2008: 11,648 / (5,261 + 6,821) = 0.96 2009: 1,189 / [5,373 + (−168)] = 0.23

2. The dividend coverage ratio has decreased considerably from 4.55 in 2008 to 1.95 in 2009.

The FCFE coverage ratio has also decreased significantly from 0.96 to 0.23. It appears that Chevron’s dividend sustainability is lower in 2009 compared to 2008.

3. Chevron’s dividend coverage has decreased significantly from 2008 to 2009.

Still, even with this decrease, Chevron’s dividend coverage is almost 2 times. Chevron’s FCFE coverage ratio has also decreased dramatically from 2008 to 2009.

This is despite the fact that the company stopped its share repurchase plan in 2009 (in fact it issued additional stock, most likely to provide shares for exercise of employee stock options).

Additionally, even if we consider 2009 to be a bad year due to a downturn in oil prices, the 2008 ratio is still below one. FCFE coverage ratio analysis therefore suggests that Chevron’s payout policy is unsustainable for the long run.