Cash Dividend Alternatives

Companies can create value for their shareholders by paying cash dividends. There are also other methods for addressing the value of a share of stock. Read this chapter, which discusses some of these methods.

Benefits of Repurchasing Shares

Share repurchases are beneficial when the stock is undervalued, management needs to meet a financial metric, or there is a takeover threat.


Learning Objectives

Discuss the benefits of a company repurchasing its shares


Key Takeaways

Key Points

  • If management feels the company is undervalued, they will repurchase the stock, and then resell it once the price of the shares increases to reflect the accurate value of the firm.
  • A member of management may have to meet earnings per share (EPS) metrics which can be increased by increasing earnings or lowering the number of outstanding shares. Share repurchases decrease the number of outstanding shares, and thus increase EPS.
  • To prevent a firm from acquiring enough of a company's stock to take it over, the takeover target may buy back shares, often at a price above market value.

Key Terms

  • hostile takeover: An attempted takeover of a company that is strongly resisted by the target company's management.
  • Earnings Per Share: EPS. (Net Income – Dividends on Preferred Stock) / Outstanding Shares

A company may seek to repurchase some of its outstanding shares for a number of reasons. The company may feel that the shares are undervalued, an executive's compensation may be tied to earnings per share targets, or it may need to prevent a hostile takeover.

For shareholders, the primary benefit is that those who do not sell their shares now have a higher percent ownership of the company's shares and a higher price per share. Those who do choose to sell have done so at a price they are willing to sell at – unless there was a ‘put' clause, in which case they had to sell because of the structure of the share, something they would have already known when they bought the shares.


Undervaluation

Repurchasing shares may also be a signal that the manager feels that the company's shares are undervalued. In this event, it will choose to repurchase shares, and then resell them in the open market once the price increases to accurately reflect the value of the company.


Executive Compensation

In some instances, executive compensation may be tied to meeting certain earnings per share (EPS) metrics. If management needs to boost the EPS of the company to meet the metric, s/he has two choices: raise earnings or reduce the number of shares. If earnings cannot be increased, there are a number of ways to artificially boost earnings (called earnings management), but s/he can also reduce the number of shares by repurchasing shares. Strictly speaking, this is a benefit to the management and executives, not the company or the shareholders. -Thwart.


Marc Benioff: CEOs, like Marc Benioff of Salesforce.com, may have to meet certain financial targets in order to earn his or her bonus. If one of these targets is EPS, they may have an incentive to try to increase EPS artificially.


Hostile Takeovers

A company can take over another firm if it holds enough of the other takeover target's shares (the buyer of the shares is called the bidder, and the company it is trying to buy is called the takeover target). The bidder is buying the takeover target's shares in an attempt to purchase enough to own it. Assuming the firm does not want to be taken over this way, the takeover attempt is called hostile. In order to prevent this from happening, the takeover target needs to prevent the bidder from purchasing enough of the shares. To do this, the takeover target will repurchase its own shares from the unfriendly bidder, usually at a price well above market value. Furthermore, it can prevent future takeover attempts. Companies with a lot of cash on their balance sheets are more attractive takeover targets because the cash can be used to pay down the debt incurred to carry out the acquisition. Share repurchases are one way of lowering the amount of cash on the balance sheet.