No. of Recommendations: 16
In the case where a company pays a dividend do buybacks also have the added value of saving the company money because you are not paying the dividend on retired shares?
Not really...they are pretty separate.
Assume shares are repurchased at fair value.
Fair value for almost any firm is well approximated by some multiple of cyclically adjusted earnings, plus a constant for any "extra" cash on hand.
e.g., a company making $1 a year with $15 per share in unneeded cash might be worth (say) $30 a share, if you assume a multiple of 15 on the earnings.
Since we are assuming they are trading at fair value, the current share price is $30.
If they use the spare cash to buy back shares,
Instead of a multiple of 15 on $1 earnings and $15 spare cash, it becomes a multiple of 15 on $2 per share earnings and no spare cash...still $30 total.
The value of a share is unchanged. Other things being equal (same valuation) the share price will still be $30 despite the lower EPS. It's shocking how few CEOs seem to understand this!
In summary, for any buybacks done at a price equal to fair value for the stock:
* The cash per share goes down
* The earnings per share go up
* Those two things exactly cancel out
* The share price is therefore unchanged
* The share count, total intrinsic value of the firm, and market cap all fall. It's a smaller firm overall.
I recap all this because it clarifies your dividend question.
Because of the buybacks, the total earnings of the firm are unchanged but the EPS goes up because the total profit is divided by a smaller number of shares.
So, assuming the total dividend remains the same--(recall that "dividend" literally means "that which is to be divided", not the per share amount!)--the coupon per share will go up because the total dividend is divided by a smaller number of shares. Of course management might choose to do something else, but if they kept the same payout ratio the dividend per share would rise the same amount as the EPS.
That's what the math says. The second order thinking would address motivations. For example, in the example above management might be more inclined to pay out a dividend before the buyback than after the buyback because they have so much spare cash. It would be relatively rational for them to think about a lower payout ratio after the big buyback.
Jim
