Dividends, Stock Splits, and Share Repurchases

According to the dividend discount model (DDM), the value of an investment should be equal to the present value of the expected future benefits. For common shares, these benefits come in the form of dividends and the expected capital gain on the sale of the stock. Therefore, to understand the model, the candidate must understand all aspects of dividends.

Dividends

A dividend is a distribution paid to shareholders based on the number of shares owned. The distribution can take one of several forms:

Cash dividend

A company pays regular cash dividends whenever it distributes a share of its profits in cash to its shareholders based on a regular dividend payment schedule. For example, the company may opt to pay shareholders a dividend every quarter, semiannually, or annually. Thus, the company could issue an annual dividend of, say, $0.50 per share. In such a scenario, an investor who owns 100,000 common shares would receive $50,000. Consistent cash dividend payouts send a positive signal to the markets, indicating that the company is growing and should continue to grow and pay dividends in the future.

Extra dividend

A company may also issue a dividend outside of the usual schedule to supplement the regular cash dividend with an extra payment. This is called an extra dividend or special dividend.

Stock dividend

Stock dividends refer to all dividend payments that are not in the form of cash. In these instances, a company chooses to distribute profits in the form of additional shares instead of using cash. For example, when a company declares a 10% stock dividend, every shareholder receives an additional 10 shares for every 100 shares they already own. When a company pays stock dividends, the total number of shares outstanding will increase but share value remains the same. In addition, a shareholder’s proportionate ownership in the company will remain the same. Likewise, his total cost basis will be unchanged since he did not purchase the additional shares; they were rather “given” to him. His cost per share will, however, be reduced. Therefore, stock dividends are not relevant for valuation.

Stock split

In a stock split, a company gives its shareholders X number of shares for every Y number of shares that are owned. For example, in a two-for-one stock split, shareholders receive one additional share for every share previously owned. Thus, if a company had 20 million shares outstanding before the stock split, it will have 40 million shares outstanding after a 2-for-1 stock split.

Reverse stock split

A reverse stock split is the opposite of a stock split. In a reverse stock split, a company reduces the number of shares outstanding by a set multiple. For example, if a company announces a 1-for-4 reverse stock split, shareholders will receive 1 share for every 4 they own. Thus, an investor with 10,000 old shares will end up with just 2,500 new shares. A reverse stock split results in an increase in the price per share but does not affect a company’s market value or shareholders’ total cost basis. For example, the same investor owning 10,000 shares at $1 will now have 2,500 shares worth $4. However, his investment in dollar terms remains $10,000.

Share repurchase

In a share repurchase, the company uses cash to buy back its own shares. Once repurchased, the shares do not participate in subsequent voting or dividend issues. The shares are also not considered when computing the earnings per share. A share repurchase is viewed as equivalent to the payment of cash dividends of equal value in terms of the effect on shareholder’s wealth, all other things being equal. It sends the message that the share may be undervalued. It can also be preferred to cash dividends when tax rates on dividends exceed tax rates on capital gains.

Question

A business worth $20,000,000 made $1,000,000 in profits in 2018. The business has 10 partners, each with a 10% stake. The company’s policy is to pay out 40% of profits every year to the owners.  In 2019, one of the owners decided to cash out although the profitability of the business remained constant. The remaining partners ended up buying out the partner. The amount received by each partner in 2019 is closest to:

1. $23,333
2. $40,000
3. $44,444

The correct answer is C. Since the buyout is executed using out-of-pocket cash, the value of the business remains the same. Instead of receiving $40,000 (= 1,000,000 × 40% ÷ 10), the remaining 9 owners will receive $44,444 (= 1,000,000 × 40% ÷ 9) even though the business did not grow. What did grow is the percentage of ownership of each remaining partner; from 10% to 11.11% (= 20,000,000/9 ÷ 20,000,000).