Non-Cash Dividends
There are other ways to pay dividends other than with cash. Here we discuss just a few of these methods.
Stock repurchases: A stock repurchase occurs when the firm goes into the open market and buys back some of its stock from shareholders. This repurchased stock is called Treasury stock. It does not go out of existence; it's placed on the shelf and does not circulate. Sometimes the repurchase will be at a price slightly above the going market price.
Typically a dollar distribution amount is divided between a cash dividend or a share repurchase since both actions require cash. Thus firms that have a high cash dividend payout tend to limit share repurchases and vice versa.
Today stock repurchases, not dividends, have become the preferred method of returning cash to shareholders. But notice that for shareholders and firm value there are subtle differences between these two types of distributions.That is a dollar returned in the form of a cash dividend is not necessarily the same animal as an identical dollar paid due to a share repurchase. The motivation of straight cash dividends is usually centered around the desire to return value to shareholders in a continuing, predictable fashion. In contrast, the carrying out of a share repurchase may have broader objectives in mind in addition to providing a current return to shareholders. While cash dividends only minimally alter a firm's capital structure by reducing equity, share repurchases tend to have a much larger impact on capital structure. Additionally, share repurchases can be part of a larger strategic plan to alter the firm's long-term capital structure to one that is more debt heavy or to one that is more in line with the firm's target capital structure.
Another reason for share repurchases is if the firm faces a large number of outstanding stock options whose exercise is imminent. In this case share repurchases will be motivated so as to have the necessary shares on hand (as Treasury shares) when option exercise takes place. This action tends to avoid dilution of ownership and voting control by keeping the total number of pre- and post-exercise shares the same.
Another reason for a repurchase is that the firm may wish to engage in a targeted stock repurchase aimed at an entity that wishes to sell a block of the firm's stock. In this case a block of shares may be repurchased from one large holder on a negotiated basis at a below-market price (say from a mutual fund or an endowment fund). Such an action might be motivated by a pending hostile takeover attempt. In this case a repurchase makes it more difficult for the takeover to occur if the buying back of shares leaves the remaining shares outstanding in the hands of investors who don't want the takeover to occur and will band together with the understanding that they are not going to sell their shares.
Other motivations exist. If management believes the firm's stock is undervalued by the market, a share repurchase may be in order. Would you buy the stock of a company at a bargain price? The answer may be "Yes." Firms think the same way—maybe things are such that they can buy themselves back at an undervalued price.
Additionally, as we have discussed, cash distributions in the form of dividends can release unwanted "signals" to the market about the health of the firm. Conversely, share repurchases don't carry all the unintended signaling baggage that accompanies cash dividends. This gives the firm more flexibility in distributing excess cash; firms can keep dividends low and stable and then use a selective repurchase to distribute cash after a good year, or halt a distribution after a bad year. This action gets (or stops) cash going to the shareholder without causing investors to expect more or less cash in the future.
While the strategic motivation of a cash dividend versus a share repurchase may be different, understand that cash distributions via a share repurchase do not, per se, change the initial value of the firm's stock. In effect all the repurchase does is transfer wealth from the firm buying shares to the selling shareholders; it does not alter aggregate wealth. And, as long as excess cash is used to pay cash dividends or repurchase stock, either plan will not alter the total market value of equity nor will it alter the total rate of return to shareholders.
Summarizing about share repurchases: Share repurchases can:
- Enhance shareholder value by increasing earnings per share and stock price.
- Alter the firm's capital structure—a repurchase constitutes a reduction in outstanding total book equity.
- Reflect the fact that the stock is under-valued in the market.
- Send positive signals to the shareholders—the firm can afford to spend the money.
- Reverse any dilution of ownership due to previous stock issuance.
- Can help avoid taxes on a cash dividend if the repurchase is at a loss to the selling shareholders.
- Can stop a hostile takeover attempt.
A stock split: With a stock split the firm increases the number of shares per share owned. For example a 2-for-1 stock split will result in the shareholder receiving two shares of new stock for every one share owned. If you own 50 shares of a firm before the split, you will own 100 shares after the split. Stock split transactions are carried out free-of-charge to the stockholder.
One chief motivation for a stock split is to lower the market price of the firm's stock into a more reasonable trading range. The idea is that when a firm's stock gets too pricey it may dissuade active trading of the shares due to the amount of capital investors must come up with to buy shares. Additionally, the brokerage costs on so-called round lots of the stock (a round lot equals 100 shares) tend to be much lower than odd lot purchases (a bundle made up of less than 100 shares). Again, because of capital constraints, an extremely high share price may make the brokerage costs associated with a lower-cost round lot too expensive. A stock split, by lowering the stock price, can alleviate this problem.
Another reason for a stock split is related to the signaling idea discussed earlier. Investors may view the split as an indication that the firm's prospects are viewed as good by the market—This positive outlook has resulted in a higher stock price which (now) needs to be lowered to a more reasonable trading range so that active trading in the stock will not be hampered.
Keep in mind that a stock split by itself has no effect on stockholder value or on the dilution of ownership and control. It's just an accounting transaction. The price per share will fall in inverse proportion to the stockholder's pro-rata proportion of new shares received. Likewise there will be no change in the post-stock dividend book value of the equity.
Stock splits are extremely common with so-called growth stocks that are experiencing a fast run-up in price. For example consider Wal-Mart during the 1980s and Home Depot during the 1990s; these companies routinely split their stock quite often over these time periods so as to keep the share price within reasonable round-lot trading ranges.
A problem: Firm X's stock is currently selling for $15 per share and is considered by management as "too high" in terms of a round lot trading range (which would be $1,500 = $15 x 100 shares). Management decides on a 3-for-2 split. What will be the new share price after the split? What will be the value of a round-lot trade?
Answer:The new share price will be 2/3rds x the original share price of $15. That is the new share price will be $10 = 2/3 x $15. The total value of a round lot after the split will be 100 x $10 = $1,000.
A stock dividend: The mechanics of a stock dividend are similar to a stock split. With a stock dividend the stockholder receives some percent increase in shares based upon the pro-rata number of shares owned. For example if an investor owns 100 shares of Company X and a 10% stock dividend is declared, the shareholder will receive an additional 10 shares. Like a stock split this action (excluding any signaling effects) will have no effect on stockholder value; price per share will fall in inverse proportion to the stockholder's pro-rata proportion of new shares received.
Problem: Company Z currently has 10,000 common shares outstanding. You own 5% of the stock of Company Z. The company has just declared a stock dividend of 10%. How many new shares are you entitled to? If the price of the stock was $30 per share prior to the split what will be the price after the split?
Answer: You own 500 shares (= 0.05 x 10,000). You can expect to receive 500 x 0.10 = 50 new shares. Your total shares after the stock dividend will be 500 + 50 = 550 shares. Before the split you owned $30 x 500 = $1,500 in value. After the split your value will be $1,500 = new share price x 550 shares. Solving for the new share price equals $1,500/550 = $2.73, Subtracting $2.73 from $30 equals $27.27 per share. The percentage change in price from $30 per share to $27 per share is -10%. The decrease in per share value is 10% and is just equal to the increase in number of shares you own. Your total wealth has not changed.
Perhaps the chief motivation for a stock dividend is to show the shareholder that the firm still remembers where's its equity capital came from in a time when it needs to conserve cash. Thus stock dividends are extremely common with cash-strapped, rapidly growing firms. With a stock dividend the firm is acknowledging the shareholders' claim to future wealth without having to part with needed cash today. In this sense stock dividends are a form of a delayed claim to longer-term expected capital gains. If the firm can conserve cash today with a stock dividend, the plowed-back cash can then be used to grow the firm's value in the future. The stock dividend today will then allow the current shareholders to partake of this additional value at some point in the future. Life is good . . .
Don't' forget the IRS with a stock dividend: Note that a stock dividend is a taxed transaction; the stockholder receives a 1099 form from the firm just as if a cash dividend had been paid. They are also required to submit this form to the IRS—and it's got your name on it. Hence one negative aspect of a stock dividend is that it can turn out to be a negative cash flow situation if the firm has not issued a cash dividend for the same period.
Signals, but no accounting change in value
As mentioned, stock splits and stock dividends, per se, do not alter the intrinsic value of the firm. They are simply accounting transactions that have no fundamental economic content. However, we often see the announcement of a stock dividend or split changing the going market price for a firm's shares. This is due to the signaling phenomenon discussed earlier. In fact, another motivation for splits and stock dividends may be linked to the firm's desire to send out positive signals to the market.
