Dividend Discount Model: Share Repurchase Programs
In corporate finance we studied that companies had an option when it came to compensating their equity shareholders. They could both pay these shareholders cash dividends from the earnings of the current year or alternatively they could conduct a share repurchase program and buy back some shares from the same proceeds. The monetary effect would be the exact same. Differences, if any would arise because of the taxation policy of the particular country.
However, when it comes to valuation, there is a huge difference between cash dividends and share repurchase programs. However, some organizations prefer to conduct share repurchases. Hence, as an analyst it is important to understand how share repurchase affects the value of a company.
This article explains the same in great detail:
Why Share Repurchase May Be Difficult To Value?
- Shares repurchase programs lead to a reduction in the number of shares outstanding. This is different because usually the number of shares remains constant. When the numbers of shares change, the per share valuation is also affected. This relationship is difficult to model and predict
- It is an unwritten rule, that dividends once announced should not be cut by the corporations. However, when it comes to share repurchases, there is no such rule. Companies do not find themselves under any obligation to conduct share repurchase year after year. Therefore, dividends are systematic and predictable whereas share repurchase may be erratic.
- There is almost always a direct correlation between earnings and dividend payout. This means that a higher profit automatically translates into a higher dividend. The same cannot be said about share repurchase. Share repurchase is driven by market price and the intention is to time the market. Hence companies may not indulge in share repurchase transactions even though they are flush with cash because they may believe that the share is overvalued at the current price. Once again, this creates unpredictability about the magnitude and timing of cash flows.
Therefore, share repurchase programs are not as reliable or as consistent as dividend payout programs. However, companies may indulge in these transactions and valuations have to be conducted.
How to Value Share Repurchases?
When dealing with share repurchase, the analyst may have to go beyond per share data. This is because the number of shares outstanding keeps on changing and hence per share data from last year may not be comparable to this years numbers. Here are the steps commonly followed while valuing share repurchases:
- The total earnings of a company are first estimated. This is done in the same manner as it is done for dividend discount models
- The amount of earnings that are to be paid out to investors is then determined. Once again the payout ratio could be obtained empirically or based on specific information that a company may have on hand
- Thirdly, the market price of the shares outstanding at that time has to be forecasted. This is the difficult and subjective part. The bid that the company makes for its own shares has to be above the prevailing market price. But estimating future prices is very difficult and is prone to a large degree of error.
- Lastly, using the amount of earnings to be distributed and the price per share, we can find out the number of shares that will be extinguished and therefore the new number of shares that will be outstanding.
- Once this is known, the valuation of these outstanding shares can also be derived.
To sum it up, the procedure largely depends on forecasting what the share price will be in the future. In the near future, an educated guess is still possible. However, predicting the stock price 5 or 10 years hence is sheer speculation and it is for this reason that analysts face problems arriving at a valuation for companies which use share repurchase as a tool to reward equity shareholders
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