Abstract
There has been done a lot of research of dividend policy for over more than 50 years ago. One research was from Modigliani and Miller. They said that when there is a perfect capital market a dividend policy would not be relevant. But a perfect capital market does not exist and dividend policy is relevant.
Next to the cash dividend and stock dividend over the last decades there has been a new way of paying back to the shareholders, a share buyback program. With a share buyback program a company repurchases shares. Over the last 5 year companies on the S&P 500 has repurchased for over 2 trillion dollar on shares. Why are companies paying so much and why shouldn’t they do a share buyback program.
By doing a share buyback program the total number of share will drop. This will cause the earning per share to rise. Because this is an important factor to investors, this will lead to an increasing share price. Another reason companies buy back shares is because they do not have any good investment opportunities.
On the long term companies that do not have a share buyback program perform better than companies that have. They use the money to invest in their own company. Another reason is that when a company keeps the earnings at a same level or even slightly decreasing, they can seemed to be improving with the earnings per share ratio increasing. The company does not perform better, but it will look like they are doing it.
So in the end if the company has good investment opportunities it is better to invest in those opportunities than by performing a share buyback program.
Contents
1. Introduction 5
2. Structure 5
3. Goal 6
4. Research question 6
5. Literature background 7
6. Share buyback program 10
7. Difference dividend share buyback program 11
8. Impact of share buyback program 12
9. Managers and CEO’s 13
10. Buybacks increase share price 14
11. Buybacks perform less 15
12. Conclusion 16
13. Literature 17
1. Introduction
If there is a perfect capital market dividend policy would not matter, according to Modigliani and Miller (1961). If that would be true than this academic paper would be useless. But is there a perfect capital market. The simple answer to that question is no. The capital market is not perfect. That is why every year CEO’s and managers company are deciding the dividend policy they use and how much of the earnings will be available for dividend and how much they would keep in reserve. The dividend policy the company choose, will be important information for the investor. They will compare it with the year before and expect at least the same dividend or the same growth in dividend. For example Shell has held the dividend at the same level last year, despite having to disinvest in the company and a decreasing oil price.
This problem has been researched for decades and different models about dividend policy have been created. It is still questionable if there is a relationship between dividends and stock prices. According to Graham and Dodd (1951), investors prefer dividends. Modigliani and Miller (1961) believe that dividend policy is irrelevant to the value of the firm. Walter (1956) and Gordon (1962) on the other hand believe that dividend policy is relevant to the value of the firm. There is a lot of difference between these researchers. In the late 20th century their came a new possibility for managers regarding the dividend policy.
The new thing was a share-buyback program. Since 1982 it is in America legal to buy back shares from your shareholders. Over the last 5 years there has been repurchased shares for over 2.1 trillion dollar.
Companies spent a lot of money on a share buyback program. Why do they do that? And it is good for the company? This will be examined in this academic paper.
2. Structure
During this academic paper there will first be discussed the problem behind the dividend policy. This will be in the literature chapter. Then the sub-questions will be answered which will lead into an answer of the research question. This answer is written down in the last chapter, the conclusion.
3. Goal
At the end of this paper the goal is to know more about a share buyback program and why it is good to have a share buyback program and what the negative aspects of share buyback program.
4. Research question
The research question that is used in this academic paper is:
What advice should be given to companies deciding on having a share buyback program?
Because there are more and more companies deciding to do a share buyback program, it is good to know whether it is good a held a share buyback program and why it is not. There will be research on the advantages and disadvantages of a share buyback program and what the difference is with regular dividend. Also the knowledge of the impact of a share buyback program will help answering the question.
4.1 Sub-questions
To answer the research question there are some sub-questions that will help answer it. First there will be a little bit about the theory behind a share buyback program. Then the difference with dividend and the impact of a share buyback program will be discussed. There will also be looked at why managers and CEO’s want a share buyback program and at last the advantages and disadvantages of a share buyback program will be written down. These answers are the basis of the advice that should be given to a company regarding a share buyback program.
• What is the theory behind a share buyback program?
• What is the difference between dividends and a share buyback program?
• What is the impact of a share buyback program?
• Why do managers and CEO’s prefer a share buyback program?
• What are the advantages of a share buyback program?
• What are the disadvantages of a share buyback program?
5. Literature background
Before doing research of a share buyback program it is good to know the problem of dividend policy. First the different problems behind dividend policy will be described. This is the agency problem, clientele effect and the information asymmetry. Than the different kind of dividend policies will be discussed. At last the preferences of investors and managers are looked into. This will also explain the agency problem and clientele effect even better.
5.1 Agency Problem
In a modern corporation there is a conflict of interest between on one hand the managers, corporate insiders, and on the other hand the shareholders, outside investors. The insiders can use the capital of the company for different purposes that can be unfavorable for the outsiders. They can use the capital to give themselves excessive salaries or they can invest in some strategies that will benefit them more personal than the company, instead of paying dividend to the outsiders. The outsiders will not be satisfied if this would happen. They have the power to appoint other directors. (La Porte, et al 2000a)
There are two alternative agency models regarding dividends. The models are the outcome model and the substitute model. According to the outcome model, a minority of the shareholders demand the corporate managers to give back cash. According to the substitute model, the corporate managers pay out dividends to create a reputation of good treatment of the shareholders. (La Porte, et al. 2000b)
5.2 Clientele effect
An important part of the dividend policy problem is the clientele effect. Because different kind of groups with investors, or clienteles, have different preferences regarding the dividend policy of the company. This is important information for the company to know what kind of group of clienteles they have as shareholders. The clienteles can prefer low dividend payouts when they are high-tax bracket investors. They can also prefer to have high dividend when the clienteles are low-tax bracket investors. (Black, 1976)
5.3 Information asymmetry
An important factor for the existents of an imperfect capital market is the information asymmetry. Information asymmetry is about the difference in information that managers and shareholders have. Managers have more information about the company and its future. Because shareholders do not have this information the information about the dividend is important to them for the prediction of future earnings. According to the information signaling theory, the information the shareholders get from the dividends will reduce the information asymmetry between the managers and shareholders. (Miller and Rock, 1982)
5.4 Dividend policies
There are different kind of dividend policies. The most common are described in that paragraph:
• Stable Dividend Policy
With a stable dividend policy the company wants a steady payout of the dividend each year. The dividend will not change if the earnings change. The amount of payout that is payed each year is a forecast of the company’s future earnings. If the dividend will grow, it will mean that the forecast of the future earnings has grown. This dividend policy is been used the most.
• Constant Dividend Policy
With a constant dividend policy the company will pay each year the same percentage of the earnings as dividend. The dividend will change a lot if the earnings of the company is not stable. This dividend policy is not used very often.
• Residual Dividend Policy
Another kind of dividend policy is the residual dividend policy. Under this policy, the company pays the dividend from the residuals that are left over. First the optimal capital structure will be identified. After this the budget that is needed for this structure will be determined and will be deducted from the earnings. The dividends will be paid from the residual earnings.
• Share buyback program
Another type of dividend policy is the share buyback program. The company will buy some of it shares back from the shareholders. Because of the payment the company makes regarding the shareholders, it is a form a cash dividends. The shareholders will receive a part of the earnings.
(Baker, et al. 1999)
5.5 Preferences of investors
Not every shareholder has the same preferences regarding the dividend policy of the company. There are a lot of different theories regarding the preferences of the investor. To get a good view the theories are categorized in three different parts. Regarding the first theory, dividend irrelevance theory, the investor does not care about dividend and the policy. The second theory, bird-in-the-hand theory, says that the investor does want dividend and the last theory, tax preference theory, says the opposite, that the investor does not want dividend.
(Baker, et al 2002)
5.6 Preferences of managers
Because some of the shareholders prefer to get some dividend it is important for a company to pay out some dividend. The total amount of dividend is important information for a shareholder. If the dividend rises it gives a positive signal to its investors. The opposite is of course when the dividend decreases. Therefor managers will want to do that as few as possible. A decrease of dividend will be less times but the decrease will be bigger than the increase. In that way the positive can be given more often. For example when the dividend of a company is 1 euro in the first year and in the second year the company has less profit and has not a bright future for the years to come, the company can decide to decrease the dividend. The dividend decrease would normally be 5 cent, but the company will let that decrease be bigger to around 10 cents. When the third year will be slightly worse than the second they do not have to decrease the dividend, but can even increase the dividend with 1 or 2 cents.
Because shareholders are the owners of the company, they are the ones the CEO is accountable to. Therefor the CEO wants to keep them as glad as possible. When the shareholders wants to get a lot of dividend, they will be satisfied with the CEO if he increases the dividend often. So the dividend can be an important factor for the CEO in order to keep his job and the shareholders satisfied.
6. Share buyback program
The sub-question answered in this chapter is:
What is the theory behind a share buyback program?
A Share buyback program is a repurchase by a company of its own stocks. Usually a company does this because it believes that the shares are valued to low. The shares are bought from the stock market or directly from the shareholders. They offer the shareholders to sell them the shares for a fixed price. The total number of shares will be lower after the share buyback program. The earnings per share will therefor increase. The company will cancel the shares they bought or they will held it as treasury shares. These share will not be longer held publicly and will not be outstanding anymore.
A reason for a company to do a share buyback program is that because of the lower total number of shares and therefor assets the return on assets and return on equity will improve. Also other metrics will improve when it is compared to before the program was held.
The share buyback program also can fill in the gap between dividends and the excess capital. A company can use this program to return something to the shareholders besides the dividend. They can pay a part of the earnings in the form of dividend and the rest to buy back some shares.
When a company repurchases shares it will show the shareholders that the corporation believes that the shares are valued to low. It is also a great method to pay back the shareholders in an efficient way. The shareholders that do not sell the shares will get a greater percentage of the shares. The share buyback program will also show that the company has enough money for emergencies and that they do not believe of any economic trouble in the near future.
A downside of a share buyback program can be that the shareholders will believe that the company does not have any opportunity for growth. The money they spent on the share buyback program could also be used as an investment in the company. Another downside can be that the money used for the share buyback program could also be set aside for any economic trouble in the future. The economic climate of the company could change in the future even if the company did not expect it. There are always factors that cannot be predicted.
7. Difference dividend share buyback program
There are some differences between regular cash dividend and a share buyback program. In chapter the advantages of dividend and share buyback program will be described to know what the differences are. This will give answer to the next sub-question:
What is the difference between dividends and a share buyback program?
Advantage dividends
A big advantage for dividends is the direct income. When a company pays dividend it goes directly to the shareholder. For investors who rely on dividends from their investments it is a huge upside. Another advantage is that the dividends can be used by the shareholders to invest in whatever they seem fit. They can spent the dividend in buying more shares from the same company or buy shares from other companies if they believe that the other shares would be more profitable. A last advantage for dividends is that the gain of the shares is certain. They will get the money and do not have to wait and see what the shares will do over the next few years.
Advantage share buyback program
There are also some advantages for a share buyback program. A share buyback program has tax advantages in comparison with dividend. When dividends are paid, there has to be paid tax at the same time with a rate of 15% or 20%. With a share buyback program the tax only have to be paid when the shares are sold, which can be years later.
Another advantage is that share buybacks are more flexible. If a company has some bad financial times it can reduce the amount of a share buyback program. Dividends will already be paid or the shareholders expect at least the same amount at the end of the year.
The earnings per share will increase. There will be less shares and with the same amount of earnings the ratio will rise. Therefor the share price will increase as well.
The last advantage is that if the company believe that the shares are undervalued, they can buy the shares and create instant value. Also they can sell them a few years later for a higher price, when the price level is the same as the company believes it should be.
8. Impact of share buyback program
In this chapter the understanding sub-question will be answered:
What is the impact of a share buyback program?
8.1 Less shares
The biggest impact a share buyback program has is the reducing of the total outstanding shares of the company. Because the total number of shares will drop the earnings and cash flow per share will rise. This will result in an increase of the share price.
For example a company has 100 million dollar in shares at a price of 10 dollar per share, 10 million shares. The get a result of 10 million dollar, price earnings ratio of 10. The use this money to buy back shares. A year later the company will have 90 million dollar as outstanding shares, the company has 10 million as result and when the price earnings ratio will stay the same the 90 million will be worth 100 million. One share will be worth 11,11 dollar, an increase of 11,11%. When the result at the end of the year will grow or the price earnings ratio will grow the share price would increase even more. Off course this example is not how it would really work in the real world, but it shows how an investment in the share buyback program will lead to a higher share price. The earnings per share would grow faster buy using a share buyback program than it would when they invested the money in improvements of the operation. Because the rise of earnings per share is high, investors are willing to pay more for that kind of stock.
8.2 Less assets
The total asset of the company on the balance sheet will decrease, because the shares are bought buy the company’s cash, which will decrease. Also the liabilities will decrease, because the shareholders’ equity will reduce, when share are bought back. This will result that the return on assets and the return on equity will improve, when the return will stay the same, because the assets and equity will decrease well the return will stay the same.
8.3 Financial spell
Not everybody is so excited about the share buyback program. There are some views about that share buyback programs are some sort of financial spell and that it is on the same level as the credit derivatives that causes the financial crisis. There are also some views that the share buyback programs are an acceptable way to return cash to the shareholders, but worry about the magnitude of the program. In their view they worry that companies will used is for a temporary good feeling and that is masks their weakness. They are also worried about an eventual buyback bubble.
9. Managers and CEO’s
This chapter will be about the preference of managers and CEO’s regarding a share buyback program. This chapter will answer the sub question:
Why do managers and CEO’s prefer a share buyback program?
9.1 Increasing bonus
When a company held a share buyback program the price of the shares remaining will go up. A manager and CEO are sometimes getting bonuses when the share price of the company increases in the year. By doing a share buyback program they can increase their own bonuses. CEO’s and directors sometimes even get the bonuses in the form of shares. When the share price would be higher they receive a higher bonus. The shares that are bought back by the company are often the shares of the directors of the company.
9.2 Increasing confidence shareholders
When performing a share buyback program the earnings per share ratio as well as the share price will go up. These are important factors to a shareholders. A shareholder will have more confidence in the board of directors if this happens. Because the board of directors must account what they do to the shareholders it is important to keep the shareholders satisfied.
By doing a share buyback program a manager and CEO create a higher bonus for themselves. They also increase their chance of keeping their jobs and the end of the year.
10. Buybacks increase share price
There are different reasons why a company has a share buyback program. In this chapter the most important reasons are described.
What are the advantages of a share buyback program?
10.1 No other investment opportunities
A company does not want to held money. It will search for a way to invest it in the company. But if there are not any investment opportunities a company can choose to do a share buyback program. In this way it will boost the share price. A company can also choose to do this if there are investment opportunities, but the opportunities are too risky at the moment.
10.2 Uncertain economic climate
Another reason why a company buy back shares is when there is an uncertain economic climate for the company. Instead of investing it in the company with a chance that the economy will get worse, they can choose to do a share repurchase. If the economy get worse and they had invested it, they could lose a lot of money of that investment.
10.3 Improving capital structure
By buying back shares the company can get the optimal structure more to the optimal value. The weighted average cost of capital (WACC) will also be reduced by doing a share buyback program.
10.4 Increasing earnings per share
When a company buy backs shares the total number of share will go down. When the earnings will stay the same a year later, the earnings per share will grow. A company does not to perform better to get this grow. This ratio, earnings per share, is an important factor for investors.
10.5 Shares are undervalued
If shares of the company are undervalued the company can buy it back. When the price level of these shares are at the level the company believed is the correct level it can sell the shares. In this way the company can create value by buying and selling its own shares.
11. Buybacks perform less
In this chapter the most important reasons why a company should not do a share buyback are described. This will give an answer to the sub-question:
What are the disadvantages of a share buyback program?
11.1 Long term
There has been some research of the S&P 1500. The companies that do not have a share buyback program perform better on the long run than companies that do have a share buyback program. Over the last 3 years the companies that did not have a share buyback program performed around a 10% return, where the companies that did have a share buyback program had a return of -2,9%. A share buyback program can help you by increasing your share price on a short term, but on the long run the companies that do not have a share buyback program will perform better.
11.2 Occur better
If a company has a share buyback program the total number of share will drop. In that way the earnings per share will increase, an important factor for an investor. But if a company performs every year a decrease in earnings, but repurchases shares, the earnings per share can increase. So the company performs worse, but investors can get the image that they are doing great and are even improving. This is misleading of investors and therefor earnings per share is not always a good ratio to get a good view of the company.
11.3 Invest in company
The money companies uses to buy back shares can also be used to invest in the company. With that money a company can make sure that the earnings will rise and the earnings per share will rise as well. So without doing a share buyback program the company can get better ratios as well.
12. Conclusion
The research question of this academic paper is:
What advice should be given to companies deciding on having a share buyback program?
When a company should choose between paying out dividend or buying back shares, it is better for the company to buy back shares, especially when the share are undervalued. The company can increase their earnings per share and in that way the share price. The share price can also increase by paying dividend, but they need to pay more every year, which is not necessary if they do a share buyback program.
Another reason to do a share buyback program is if they do not have any good investment opportunities that are not too risky. They can do the share buyback program until they find a good investment opportunity.
But if you compare all the pros and cons of a share buyback program the cons outweigh the pros. Off course by doing a share buyback program the company can increase the share price and get a higher earnings per share, but they can use this money also buy investing it in the company. In this way they can get the same results. They will also perform better on the long run and will not show a better image of themselves.
A share buyback will be a better choice if the company choses between a share buyback program and dividend, but if they choose between a share buyback program or investing it in the company, it is better to choose the last option.
13. Literature
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