By: Tracy Porter
Copyright 2007
On 7 September 2007 Nils Pratley wrote an opinion piece entitled, “Advice from a veteran to get personal”, and in this piece he commented on Drax, a company that opted for a share buyback instead of returning any excess monies to the shareholders via a special dividend. Pratley commented that, “its usually only vanity that makes managements think their own company’s shares are the best investment in town” (Pratley, 2007).
While Pratley made reference to several companies, such as BP and GlaxoSmithKline, which have been engaging in share buybacks for the last several years, he did not quantify his reasoning behind his statement. One can wonder, therefore, if he seriously considered recent legislation as well as two well researched hypothesizes before putting his opinions onto paper. The two hypothesizes, which have received much critical analysis for the last half a century, are the Modigliani-Miller theorem and the Efficient Market Hypothesis.
The Efficient Market Hypothesis
Eugene Fama wrote “The Behavior of Stock Market Prices”, which was published as the entire January 1965 issue of the Journal of Business. Following on from this work, Fama then conducted an event study that sought to analyse how stock prices respond to an event. These theoretical and empirical studies conducted by Fama were recorded in his article entitled, “Efficient Capital Markets: A Review of Theory and Empirical Work”, which was published in the May 1970 issue of the Journal of Finance.
It was Fama’s work on the efficient capital markets that gave birth to the Efficient Market Hypothesis, which proposes that a market’s efficiency is directly proportional to the information that is made available to investors. Fama proposed three levels of efficiency, which are weak, semi-strong, and strong, and are distinguished by the degree of information reflected in security prices. In the weak form of market efficiency, share and commodity prices reflect the information contained in the record of past annual returns and prices, and consequently, it would be virtually impossible for an investor to make consistently competitive profits by studying past returns because the prices will follow a random walk. In the semi-strong form of efficiency, the share and commodity prices reflect past prices and all other published information, and as a result the prices will tend to adjust immediately to the public information made available to investors. In the strong form of efficiency, the share and commodity prices reflect all available information that can be acquired by painstaking analysis of the company and economy in general (Brealey et al, 2006).
In his work, Fama defined an efficient market as one in which prices always “fully reflect” available information and stated sufficient conditions for market efficiency as being:-
(i) no transactions costs in trading securities,
(ii) all available information is costlessly available to all market participants, and
(iii) all agree on the implications of current information for the current price and distributions of future prices of each security.
Fama believed that a market is called “efficient” if investors who possess information nevertheless earn only a competitive expected return from investing in a particular company (University of Leicester, 2007).
Referring back to the example that Nils Pratley cited at the beginning of this paper, Drax plc at the very least had a semi-strong form of efficiency because investors would have had access to the company’s financial statements as well as published press releases. With this in mind, once Drax announced that it was going to opt for a share buyout rather than a special dividend, in theory the market would have adjusted immediately to this news. Whilst the market did adjust to the news of the share buyback, the adjustment was not necessarily in favour of Drax. One reason for this is because Drax’s ordinary and special dividends in 2007 had the potential to deliver a cash yield of 8%. If shareholders get only ordinary dividends, however, the yield is only 2.2%, which meant that Drax is no longer an income stock. Those investors who purchased shares in Drax in order to gain a regular income, therefore, would sell their shares and look to invest in a company that would pay dividends (Pratley, 2007). Of course, those same investors could very easily engage in arbitrage techniques, which include either selling part of the shareholding to generate sufficient cash to replace the dividend missed or to borrow the money at the perfect market rate of interest in order to gain an income (Lumby and Jones, 2003). Many investors who rely on their dividends as income do not care to do this however, and would prefer to invest in a company that pays dividends, which is apparently what happened in Drax’s case.
A study by the US investment bank, Morgan Stanley, found that if the purpose of a share buyback is to boost a company’s share price, returning cash to shareholders through raising the dividend is a far more effective method that can be used to achieve that goal. Since 1997, the share price rise of companies that have consistently increased their payout has been 12.7% a year, as opposed to the 10.3% gain of the overall market. However, the average performance of companies that pursued share buybacks was only 8.2%, which is 4.5% lower than the companies that gave generous dividends. The result of this study concludes therefore that stock markets will reward companies that grow their dividends strongly, but appear on average to penalize those companies that conduct buybacks (Hassell, 2007).
There are some instances, however, when it would be propitious to engage in share buybacks rather than issue a special dividend. Megacap companies, which are companies that are too large to acquire capital through private equity companies, have tended to popularize the practice of share buybacks. In 2006 58% of British companies were engaged in buyback operations, compared to just 14% in 1997. In that same year, 90% of British share buybacks by value have been undertaken by only 20 publicly listed companies.
Table 1
Companies Engaged in Share Buybacks 2006
Company Share
Buyback
£ bn
Vodafone 8.8
BP 8.4
Royal Dutch Shell 2.9
AstraZeneca 2.2
Anglo American 2.0
Total 24.3
Although the above listed companies have engaged in share buybacks, they have also under performed in the overall market in recent years (Durrant, 2007). It is worth noting, however, that the five publicly listed companies cited above are in both American and British stock exchanges, which means that they must comply with appropriate legislation of both countries.
One of the reasons why companies announce buybacks is because they feel their stock is undervalued, and it is hoped that buying back stock and effectively decreasing the number of shares available for purchase will raise the share price. It is important in any share buybacks, however, that the company’s executives are not among the selling shareholders. If the company executives sell their shares during a buyback, this will send a negative message to potential investors and the company management may not achieve the desired result form the buyback procedure. When company executives don’t sell their shares during a stock buyback, this can send a positive message to potential investors, and academic research has shown that the best performing share buybacks are those where company executives are not sellers (Durrant, 2007).
The process by which a share buyback can increase the value of the share is illustrated below:-
TABLE 2 Company TRP Year 1 Year 2 Year 3 Earnings £100 (paid as dividends) £100 (stock buyback) £100 Shares 1000 900 900 Shareholder equity £1000 £900 £1000 Earnings per share (EPS) £0.10 £0.10 £0.11 Return on equity (ROE) 10% 10% 11.1% Price Earnings (P/E) Ratio 10 10 10 Price per share £1 £1 £1.11 Debt £500 £500 £500 Debt Equity (D/E) Ratio .5 .56 .5
Take the hypothetical company TRP. In year 1 TRP earns £100, which it decides to give back to the shareholders as a dividend payment. It has 1,000 shares and £1,000 in shareholders equity, so the price of each share will be valued at £1. Since TRP is going to pay the £100 as a dividend, the earnings per share (EPS) will be £0.10, the return on equity (ROE) will be 10% and the price earnings (P/E) ratio will be 10.
In year 2 company TRP also earns £100, but instead of paying the money back to the shareholders as a dividend, it decides to buy back 100 shares at the current market rate of £1 per share. TRP will therefore have 900 shares and £900 in shareholder equity. The EPS will remain at £0.10, the ROE will remain at 10%, and for purposes of this illustration, the P/E ratio will remain at 10.
In year 3, TRP also earns £100, which will bring the shareholders equity back up to £1,000, thus bring up the price of a share up to £1.11. If the P/E ratio remains at 10, this will cause the EPS to raise to 11.1%, so any dividend payments would be £0.11 per share, as opposed to the previous £0.10 per share in year 1 and year 2 (iii.co.uk, 2007).
Because stock buybacks are intended to raise the value of the stock, quite often just the announcement that a company is going to buy back stock is enough to raise the value of the stock in question. The announcement of a stock buyback adds on average 2% to a company’s share price immediately, partly because of the impact the reduction in shares in issue will have in the future, and partly because of the positive message the action intends to convey about the financial welfare of the company. Therefore, using company TRP as an example, the announcement that 100 shares were to be bought back and cancelled would in theory immediately bring the price of a share up to £1.02, which is 2p up from the £1 original share price (iii.co.uk, 2007).
The announcement of a buyback can be a statement that managers are so confident about the future of their company that they believe the best investment they can possibly make is in the company’s own shares. Taking the fact that an announcement of a share buyback will in theory increase the value of the shares by 2%, some companies will announce share buybacks in an attempt to bring the value of the share price up, and having achieved their plan to buyback the stock. For instance, a study of over 400 companies that announced stock buybacks found that nearly 40% of those companies failed to follow through with their plan in the next five-year period. Professor James Westphall of the University of Texas appropriately stated, “increasing the stock price may be their first objective, and once met, implementation may be less critical” (iii.co.uk, 2007).
Modigliani-Miller Theorem
In the 1958 edition of the American Economic Review an article written by Franco Modigliani and Merton Miller entitled, “The Cost of Capital, Corporation Finance, and the Theory of Investment.” This was a pivotal piece in the science of finance and is probably what turned it into a separate discipline in its own right (Poulson, 2006). In its basic form, the Modigliani-Miller theorem states that in the absence of taxes, bankruptcy costs and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. This theory states that it does not matter if a firm’s capital is raised by issuing stock or selling debt, and it does not matter what the firm’s dividend policy is (Lumby and Jones, 2003).
Dividend policy is perhaps that least analysed and most elusive area of financial decision making, but is nevertheless a very critical factor that must be taken into account when attempting to forecast a company’s future wealth because the dividend policy can play useful role in informing the market about earnings growth opportunities envisaged by management (University of Leicester, 2007). It is because capital markets are imperfect in the sense that information is neither costless nor universally available that decisions are often made by stock market investors on the basis of imperfect and incomplete information, which means the market is not as efficient as it needs to be in order to make educated decisions. Because capital markets are imperfect, the dividend declaration, which is a free and universally available piece of data, is often thought to signal information about a company’s performance. It is because the declaration of a dividend decision holds such importance to the investor that many publicly listed companies will not reduce or pass a dividend unless it is in the most dire of financial circumstances. In order to illustrate this point, several studies have shown that an increase or decrease over the expected level of dividends does precipitate a respective rise or fall in the market share price (Lumby and Jones, 2003).
Whilst there are several reasons why a company might opt to buy back shares, one of those reasons is that they wish to change their capital structure by replacing equity with debt (Brealey et al, 2006). A company’s capital structure is defined as the way that companies finance themselves through a combination of equity capital and debt capital. Equity capital is that capital that is acquired through the selling of options, bonds, and stocks; and those individuals who purchase equity capital are considered to be part owners of the company, or shareholders, and they have a say in how the company is managed. Debt capital consists of loans that the business takes out and the owners of debt capital generally do not have any say in how the company is managed.
There are several advantages to using debt capital instead of equity capital, and perhaps this is one reason why companies would repurchase stock to change their capital structure. Owners of debt capital are merely creditors and do not have any ownership of the company. Once the debt has been repaid, or redeemed, the lender has no further stake in the company. Suppliers of debt capital are contractually entitled to receive an annual percentage return, or coupon rate, on the loan, which must be paid before any dividends can be paid out to shareholders. Because the payment of interest takes priority over the payment of dividends, debt capital is considered to carry less risk than equity capital (Lumby and Jones, 2003). Many countries allow companies to offset the debt interest against their corporation tax liability, so debt interest is essentially tax-free and is subsidized by the government. Equity capital, on the other hand, is taxed twice because the company must pay corporation tax on its profits before dividends are paid to the shareholders, and the recipients of those dividends must also pay capital gains tax. It is worth noting that in the UK in 2007 corporation tax is 30% and dividend income can be taxed at 10% or 32.5%, depending on the recipient’s personal circumstances (qck.com, 2007).
TABLE 3 Company TRP 10% tax £ 32.5% tax £ Profit after interest payments and other deductions. 100 100 Corporation tax (30) (30) Profit for the financial year 70 70 Shareholder’s tax (7) (22.75) Shareholder’s remaining funds 63 47.25
Referring back to the example of company TRP, it would be obliged to pay 30% on any profits, so the £100 earnings cited in Table 1 would in fact shrink to £70. Dividend income would be taxed at either 10% or 32.5%, which would amount to either £7 or £22.75. The dividends received would be either £47.25 or £63, so the original profit of £100 would be taxed at a rate of either 37% or 52.75%. Debt equity, in contrast, would in most cases be tax-free. Those individuals who are vehemently opposed to paying taxes, therefore, would prefer a stock buyback to a dividend payment.
When a company decides to repurchase stock in an effort to change its capital structure, it is endeavoring to change its gearing. Gearing, or leverage, is defined as the ratio of the total market value of a company’s debt capital to the total market value of its equity capital.
The formula for gearing, which is called the debt to equity ratio, is expressed as:-
Formula 1
If one refers back to Table 1, company TRP has taken out loans amounting to £500. In year 1, when TRP has decided to pay out dividends, the debt to equity ratio is .5. In year 2, when TRP has decided to repurchase 100 shares, the debt to equity ratio has increased to .56. In year 3, however, when the price of shares have increased as a result of the stock buyback, the debt to equity ratio has gone back down to .5.
According to the Modigliani-Miller theorem, in the absence of taxes, bankruptcy costs, and agency fees, it makes no difference if a firm’s capital is raised by issuing stock or selling debt, and this analogy is expressed as:-
Formula 2
Since, according to Modigliani and Miller, it makes no difference whether a company acquires its capital from debt or equity, all things being equal, it would be better to finance the company with debt capital than equity capital (Lumby and Jones, 2003). If a company were to ardently pursue such a tactic, therefore, it would repurchase all of its stock and rely solely on debt to acquire capital. In practical terms, however, this practice rarely, if ever, happens because the higher debt a company incurs, the higher the risk of default of the loan, and the issuers of debt capital will require higher interest payments and covenants to limit the company’s activities. Therefore, while in principal it would be perfectly acceptable for a company to be wholly financed through debt capital, in practice most companies rarely have a debt to equity ratio higher than .5.
Appropriate Legislation
Other factors that need to be taken into consideration when contemplating the issue of stock buybacks are that of recent legislation. In the early years of this century there were several company failures that had a deep impact on employee pensions, shareholder wealth, and the global economy. In America, the company failures that received global attention included Worldcom, Enron and Tyco. Company scandals, however, were not confined to the United States, but involved a number of major European concerns, such as Vivendi, Armalat and Ahold; companies that sought to emulate Anglo-Saxon business practices (Blackburn, 2006).
As a result of these significant business failures, several countries, to include the United States, Canada, Australia and Japan, have endeavoured to move towards a more rules based accounting approach in an effort to restore public confidence in publicly listed companies and the stock market. In the United States, the Sarbanes-Oxley Act was signed into congress on 30 July 2002 in an attempt to redress the legislative deficiencies that failed to prevent those corporate collapses that shook America to the core.
Of particular note in the Sarbanes-Oxley Act is section 302 of the Act, which requires the Chief Executive Officer (CEO) and the Chief Financial Officer (CFO) to certify that the financial statements and other information included in each quarterly report are true and accurate presentation in all material aspects. If accounting irregularities are found in the company, the CEO and CFO can be fined up to £3m or go to prison, or both (Giles, 2007).Although Sarbanes-Oxley is an American Act, it concerns all publicly listed companies in the United States and foreign companies that are listed on American stock exchanges with 500 or more US based shareholders to make themselves compliant (Giles, 2007).
Although Sarbanes-Oxley has restored public confidence in the stock market, this renewal of trust has not come without difficulties because it is very costly to implement. A Financial Executives International (FEI) survey in 2004 found that the first year of complying with section 404 of the Act, which covers traditional financial processes, as well as those areas that have an indirect financial impact to include processes, procedures, compliance, and controls, cost an average of $4.5m, with the cost gradually decreasing to $2.9m spent in the fiscal year 2006. The survey found that whilst Sarbanes-Oxley raised investor confidence, most managers felt the cost outweighed the benefits (FEI, 2007). To illustrate this point, in November 2004, Accountancy Age magazine reported that between 10 and 20 major UK companies were considering delisting from American stock exchanges as a result of the rapidly increasing costs of compliance. One of the highest profile delistings was that of Lastminute.com, which quit the NASDAQ in August 2004 (Giles, 2004).
Another negative effect of the Sarbanes-Oxley Act is the fact that publicly listed companies in American stock markets are less inclined to take risks. Leonce Bargeron, Kenneth Lehn and Chad Zutter, of the University of Pittsburgh have found that compared to similar British companies, American companies have significantly reduced their investment in research and development (R&D) and overall capital spending, while increasing their holdings of cash (The Economist, 2007).
If the Sarbanes-Oxley Act has had the effect of making publicly listed companies less eager to take risks and invest in R&D, as well as increase their holdings of cash, it is not surprising that those companies would endeavour to decide to buy back stock with their earnings. If they buy back stock they will potentially increase the value of their current stock as well as reduce the number of shareholders who own that stock. Even if the companies buy back stock in an attempt to rebalance their capital structure, this would still in theory be a positive move because they would be retiring expensive equity in favour or cheaper debt financing.
Conclusion
After having critically analysed Nils Pratley’s statement, “It’s usually only vanity that makes management think their own company’s shares are the best investment in town,” this writer has come to the conclusion that he did not back his statement up with fact and contextual references. There are several reasons why a company would choose to buy back stock, which are justified by the Efficient Market Hypothesis, the Modigliani-Miller theorem, and appropriate legislation, and they do not necessarily involve vanity on the part of company management. The reasons why a company would choose to buy back stock include, but are not limited to:-
(i) to increase the share price,
(ii) to rebalance the capital structure,
(iii) to substantiate dividend payouts with share repurchases because capital gains may be taxed at a lower rate than dividend payments,
(iv) to prevent the dilution of earning caused by the issue of new stocks,
(v) to deploy excess cash flow and return it to its shareholders (Global Investor, 2007),
(vi) and finally, although this is less obvious and has not been explicitly stated as a reason for stock repurchases elsewhere, in an attempt to err on the side of caution to comply with appropriate legislation.
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