Strategic Corporate Finance: Applications in Valuation and Capital Structure

HOW DIVIDENDS AND BUYBACKS CREATE VALUE

Beyond understanding your own capital position and future needs, you must understand how dividends and share repurchases affect value to determine if you should distribute money to shareholders and what the mix of dividends and repurchases should be.

On the face of it, the popularity of share repurchases is easy to understand. By purchasing its own stock, a company reduces the number of shares outstanding without affecting its reported earnings (ignoring foregone interest income). Generally speaking, that increases the company’s earnings per share (EPS), but that is not how buybacks create value. Contrary to the conventional wisdom, buybacks do not create value by increasing earnings per share. The company has, after all, spent cash to purchase those shares, and company’s intrinsic value is reduced by the amount of capital redeployed, reflected by reductions in cash and shares. Indeed, if increasing EPS were the only rationale for buybacks, there would be no impact on value, which, as we have seen, is not the case.

A similarly misguided view of value creation for dividends is frequently espoused. Dividend policy clearly affects the marketability and ownership composition of new issues and seasoned stocks alike. Therefore, conventional wisdom has it that long-term supply/demand relationships may be affected through the fine tuning of a cunning dividend policy. However, for the majority of stocks, the level of dividends has no bearing on its ...