Buybacks and Dividends Stock Buy-Backs

Buybacks and Dividends

Stock buy-backs and one-time special dividends have accounted for sixty-three percent of total dividends of companies in the United Kingdom since 2003. Ordinary dividend growth has failed to keep pace with earnings growth in the United Kingdom as well as the rest of Europe. While one would not expect this to be necessarily bad news for the investor, European companies have discovered that their buy-back and special dividend preferences in recent years have failed to boost companies' share prices. As a result, they are now turning to back to increasing dividends as the preferred way to return capital to investors (Hughes and O'Doherty, 2007).

However, it's not clear if the policy shift from stock buy backs to regularly scheduled dividends by European firms will make a real difference in the overall net gains of investors. According to the dividend principle, if there are not enough investments that earn the hurdle rate, companies should return the cash to stockholders (Returning cash to owners: the firm's payout policy). but, which method really benefits stockholders the most is highly dependent on the context of the reason for the stock buyback or dividend policy and the stockholder's individual preferences and tax situation. Only once these are understood, can the stockholder assess the type of policy that is in his or her best interest. This paper discuses the advantages and disadvantages of stock buybacks and dividends so that stockholders can make more informed investment decisions.

2.0 Stock Buybacks

If a company buys back shares in the open market, it helps support the share price as shown in the following simplified example:

Company: ABC Corporation

Stock Price: $50 per share

Shares Outstanding: 100,000

Market Capitalization: $5,000,000

In this example, each share equals.001% of ownership in the company.

The company decides to buy back 20,000 shares for $1 million dollars. This means that there are now only 80,000 shares of ABC. Therefore, a stockholder's stock now represents.00125% of the company instead of.001%, a 25% increase in value per share. The stock in ABC is now worth $62.50 per share instead of $50 (Kennon). Conventional logic regarding this situation is fairly straightforward; shareholders win. but, as we shall discover, there are disadvantages as well.

2.1 Stock Buyback Advantages

Stock buybacks improve a firm's financial ratio. Although a stock buyback reduces cash, return on assets increases because the cash component of assets on the balance sheet is reduced. Return on equity increases because there is less outstanding equity. The buyback also helps to improve the company's price-earnings ratio due to the reduction in outstanding share. All of these metrics, particularly the price-earnings ratio, are considered important metrics to judge investment in a company and their improved positions due to the stock buyback may lead to additional stock demand/appreciation. In addition, stock buybacks send a strong signal to the market that a firm's management believes the shares are undervalued (Palley, 2007).

Historically, companies that have aggressively repurchased their shares typically have had better returns than the broader market. Since 1984, seventy percent of the time, those kinds of companies have outperformed the market (Buy backs vs. dividends, 2006). And investors have more control over if and when they realize their capital gains.

2.2 Stock Buyback Disadvantages

Critics charge that buybacks artificially prop up earnings per share which misleads investors. Some say that companies use aggressive buyback programs to manage earnings during weak periods and to mask the number of options they have granted to employees so that shareholders will not see dilution in their positions (Buy backs vs. dividends, 2006).

And, we've all heard stories of management compensation incentives consisting of huge stock options that encourage management to manipulate stock prices upward.

3.0 Dividends

According to the Miller-Modigliani Hypothesis, dividends do not affect value. This theory reasons that if a firm's investment policy doesn't change, the value of the firm cannot change with dividend policy. Therefore, investors should be indifferent to receiving either dividends or capital gains. but, the Miller-Modigliani Hypothesis has underlying assumptions that don't hold in the real work. It assumes there are no tax differences between dividends and capital gains and that companies do not use the excess cash they have as result of not paying the dividends for bad projects or acquisitions (Dividend policy). As these situations occur, there are distinct advantages and disadvantages of dividends

3.1 Advantages of Dividends

Stockholders may value regular cash payments that dividends offer and many may not face the tax disadvantages of dividends (discussed in the next session of this paper). and, unlike volatile stock prices firms generally do not change their dollar dividends frequently; dividends are said to be "stick."

Dividends tend to follow a much smoother path than earning do. (Returning cash to owners: the firm's payout policy).

Dividends now are more certain than capital gains later and this is often considered an advantage of dividends. but, this does not mean that dividends are more valuable than capital gains because the appropriate comparison should be between dividends today and price appreciation today. Unfortunately, this is a common fallacy known as "the bird in the hand fallacy" and it should be avoided when comparing dividends to capital gains (Dividend policy).

A firm's change in dividend policy sends a strong market signal about their future cash flows; a dividend increase indicates that the firm expects to have higher future cash flows which translate into higher share prices. Further, making a commitment to pay dividends imposes financial discipline on managers who are under greater pressure to make sure that free flow cash flows are not wasted (Returning cash to owners: the firm's payout policy).