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1 Dividends and Share Repurchases Pablo Fernandez Professor of Finance Camino del Cerro del Aguila Madrid, Spain Previous versions: 2000, 2002, 2010, 2013, 2015 October 18, 2017 The share value is the present value of the expected equity cash flows, and the two main components of equity cash flows are dividends and share repurchases. We focus on the evolution of dividends and share repurchases on the U.S. stock market, although we also provide some data about other countries. We show the evolution of the dividend yield of GE, Boeing and Coca-Cola. We compare the evolution of the yield on 30-year Government bonds and the dividend yield in the United States. Both yields have fallen in the last 30 years. We compare the evolution of the dividends per share of Coca-Cola and Pepsico with the earnings per share, and we calculate the expected dividend growth of Coca-Cola and Pepsico.implicit in the market prices. 1. Evolution of dividends on the U.S. stock market 2. Companies that distribute dividends and make share repurchases in the USA 3. Evolution of dividends on the international markets 4. The share value is the present value of the expected equity cash flows 5. Share value when dividends have constant growth. Gordon and Shapiro formula Appendix 1. Derivation of the Gordon and Shapiro formula Appendix 2. Dividends in different stock indexes Tables and figures are available in excel format with all calculations in: CH28-1

2 1. Evolution of dividends on the U.S. stock market Figure 1 shows the evolution of the dividend yield 1 of three of the largest North American companies: GE, Boeing and Coca-Cola. Figure 1. Evolution of the dividend yield of GE, Boeing and Coca Cola. Source: Datastream Figure 2 shows the evolution of the yield on 30-year Government bonds and the dividend yield in the United States. Both yields have fallen in the last 20 years. Although Figure 2 seems to show that the yield on Government bonds has always been greater than the stock market s dividend yield, Fisher & Statman (2000) show that the dividend yield was greater than the yield on Government bonds in every year from 1879 to The average difference during those years between the dividend yield and the yield on Government bonds was 1.87%. Figure 2. Dividend yield and yield on 30-year Government bonds in the United States. Source: Datastream 2. Companies that distribute dividends and repurchase shares in the USA Until 1998 there were increasingly fewer companies that distribute dividends. In 1998, only 20.7% of the 5,655 companies listed on the main US stock markets (NYSE, AMEX and NASDAQ) paid dividends. Table 1. Dividend distribution by companies listed on the main US stock markets (NYSE, AMEX and NASDAQ). Source: Fama and French (1999) Number of companies 787 2,531 3,742 4,391 4,326 5,202 5,655 Paid dividend 74.7% 65.5% 58.3% 36.3% 29.5% 24.5% 20.7% Did not pay dividend 25.3% 34.5% 41.7% 63.7% 70.5% 75.5% 79.3% Did pay Never paid ,182 2,257 2,526 3,397 3,981 As Table 1 shows, of the 4,484 companies that did not pay dividends in 1998, 3,981 companies had never paid dividends since they were incorporated, and 503 companies had paid dividends in previous years. Itemizing by markets, in 1998, 52% of the companies listed on the NYSE, 19% of the companies listed on the AMEX, and the 9% of the companies listed on the NASDAQ paid dividends. Table 2 shows the reduction of the dividend yield. This reduction is not only because less companies pay dividends. The dividend yield of the companies that do distribute dividends has also fallen from 4.7% in the 80 s to 2.2% in the 90 s. It also shows that stock repurchases are increasing. The reason is that it is 1 The dividend yield is the dividend per share (DPS) divided by the share price (P). CH28-2

3 fiscally more efficient for shareholders to distribute money in the form of stock repurchases than by paying dividends. Stock repurchases as a percentage of profits increased from 3.5% in the mid-70 s to 27.1% in the 90 s. Table 2. Selected financial data on the companies listed on the main US stock markets (NYSE, AMEX and NASDAQ). Source: Fama and French (1999) Dividend/Market capitalization Total companies 3.1% 4.4% 3.1% 2.6% 1.7% Dividend payers 3.2% 4.7% 3.5% 3.0% 2.2% Share repurchases/net income 3.5% 4.9% 24.7% 27.1% 27.1% Dividend/net income 33.9% 35.2% 40.7% 55.8% 40.3% (Repurchase + Dividend)/Net income 37.4% 40.1% 65.4% 82.8% 67.3% Share issues/net income 8.7% 11.4% 23.0% 32.2% 34.0% ROE. Dividend payers 12.8% 14.5% 12.0% 10.7% 13.3% ROE. Non dividend payers 7.6% 8.4% 4.4% 3.4% 3.9% Share of total market capitalization Dividend payers 96.3% 94.1% 88.4% 86.8% 77.5% Non dividend payers 3.7% 5.9% 11.6% 13.2% 22.5% Figure 3. Cash payments to shareholders: dividends and stock repurchases (North American companies included in COMPUSTAT) Between 1995 and 1999, North American companies announced stock repurchase programs with a total value of 750 billion dollars. In 1998, for the first time in history, North American companies distributed more money to shareholders through stock repurchases than through dividends, 2 as can be seen in Figure 3. The large increase in stock repurchases is related with the increase in employee options. Kahle (1991) finds that firms announce repurchases when executives have large numbers of options outstanding and when employees have large numbers of options exercisable. She also finds that the shareholder return due to the announcement of a stock repurchase is significantly lower for firms with large amounts of employee stock options. In the USA, the Tax Relief Act of 2003 effectively eliminated the tax disadvantage of dividends. Floyd, Li and Skinner (2011) 3 studied the dividends and the repurchases of industrial and financial firms in the USA in the period Their main findings were the following ones: a) Industrials and financials both increased payouts in the years prior to the crisis, at a pace that was impressive both in absolute terms and relative to earnings. b) Dividends reach a low point in 2002 but rebound thereafter. c) Industrials, and especially dividend payers, have increasingly used repurchases to supplement dividends, so that overall payouts (relative to earnings) have increased until d) Financials have a greater propensity to pay and increase dividends than industrials. Floyd, Li and Skinner (2011) point out that Why managers pay dividends remains a puzzle. The following figures illustrate this article. 2 See Grullón & Ikenberry (2000). 3 Floyd, Eric, Li, Nan and Skinner, Douglas (2011), Payout Policy Through the Financial Crisis: The Growth of Repurchases and the Resilience of Dividends, Chicago Booth Research Paper No Available at SSRN: CH28-3

4 Figure 4. Number of INDUSTRIAL firms that pay dividends and make stock repurchases Figure 5. Number of INDUSTRIAL firms that pay dividends and make stock repurchases Figure 6. Number of FINANCIAL firms that pay dividends and make stock repurchases Figure 7. Number of FINANCIAL firms that pay dividends and make stock repurchases Figure 8. Amount paid by INDUSTRIAL firms in dividends and repurchases (US$ million) CH28-4

5 Figure 9. Amount paid by INDUSTRIAL firms in dividends and repurchases (%) Figure 10. Amount paid by FINANCIAL firms in dividends and repurchases (US$ million) Figure 11. Amount paid by FINANCIAL firms in dividends and repurchases (%) Figure 12. Aggregate earnings of INDUSTRIAL firms (US$ millions) Figure 13. Aggregate earnings of FINANCIAL firms (US$ millions) CH28-5

6 Figure 14. Amount paid to shareholders / Aggregate earnings of INDUSTRIAL firms (%) Figure 15. Amount paid to shareholders / Aggregate earnings of FINANCIAL firms (%) 3. Evolution of dividends on the international markets Table 3 shows the evolution of dividends, profits, GDP and CPI in several European countries during the period Figure 16 shows the evolution of the dividend yield in United States, England and Germany. The dividend yield has fallen in all markets in the last 10 years. Table 3. Growth of the nominal and real dividends per share in several European stock markets ( ). Source: Hoare Bovett Germany France Italy Holland Spain Sweden Switzerland UK Nominal dividends 3.4% 9.1% 11.2% 6.0% 9.6% 9.5% 4.7% 11.7% Real dividends 0.4% 3.4% 2.0% 3.1% 1.7% 4.4% 1.7% 5.0% Net income 4.7% 8.1% 10.3% 6.6% 8.3% 13.2% 5.6% 10.9% Real GDP 2.6% 2.1% 2.1% 2.2% 2.2% 1.4% 1.4% 2.1% Nominal GDP 5.8% 7.7% 12.1% 4.6% 11.9% 8.1% 8.1% 9.1% CPI 3.0% 5.7% 9.2% 3.0% 9.4% 5.5% 5.5% 6.7% Figure 16. Evolution of the dividend yield on the German, English and North American stock markets. Source: Datastream CH28-6

7 4. The share value is the present value of the expected equity cash flows A share s value is the current value of the expected dividends 4. Further on, we shall see several methods for valuing companies by discounting expected dividends. The methods vary depending on how dividends are expected to grow. The investor who buys a share today normally expects to receive dividends in the future 5 and resell the share in the future at a higher price. It may also be the case that he buys the share with the intention of holding it indefinitely. Let us imagine that the investor who intends to hold the share indefinitely buys it today. A company that distributes dividends each year has issued the share. If the return that our investor requires from the investment is Ke, the maximum price that he must pay for this share (P 0) is the present value of the dividends (DPS) that he expects 6 to obtain from the share [1] P 0 = DPS Ke DPS 2 (1 + Ke) 2 DPS 3 (1 + Ke) 3 DPS 4 (1 + Ke) 4... Another investor expects to receive dividends for the next two years (DPS 1 and DPS 2) and then sell the share at a price P 2. If the return that our investor requires from the investment is Ke, the maximum price that he must pay for this share (P 0) is: P 0 = DPS Ke DPS 2 + P 2 (1 + Ke) 2 However, the investor who buys the share in two years time will make a calculation similar to his. Assuming that he too wishes to hold it for two years, the calculation he will perform to obtain the share s price in two years time (P 2) will be: P 2 = DPS Ke DPS 4 + P 4 (1 + Ke) 2 However, the price in year 4 will also depend on the following years dividends. Repeating this reasoning, we obtain: DPS P 0 = 1 DPS Ke (1 + Ke) DPS 3 2 (1 + Ke) DPS 4 3 (1 + Ke)... 4 Consequently, the share s value is the present value of the dividends that the share is expected to generate, even if the investor is thinking of selling it soon. Example. Calculate the value of a share that distributes an annual dividend of 100 dollars and which is expected to remain constant over time. The yield on long-term Government bonds is 6% and the required return from this company is 10%. The share s value is 1,000 dollars because P 0 = 1, 000 = (1.1) 2 (1.1) 3 (1.1) 4 Note that if instead of expecting those 100 dollars from the investment in the share, they were expected from a perpetual Government bond, its value would be 1,667 dollars (higher because it has no risk): 1, 667 = (1.06) (1.06) (1.06) Share value when dividends have constant growth. Gordon and Shapiro formula We now address the valuation of a share whose dividends are expected to grow each year at a rate g. DPS 1 = DPS 0 (1 + g) DPS 2 = DPS 0 (1 + g) 2 = DPS 1 (1 + g) DPS n = DPS 0 (1 + g) n = DPS 1 (1 + g) n-1 The share s price will be: P 0 = DPA Ke DPS 1 (1 + g) DPS 2 1 (1 + g) DPS 3 1 (1 + g)... (1 + Ke) 2 (1 + Ke) 3 (1 + Ke) 4 4 When we talk about dividends, we are referring to payments to shareholders (equity cash flows). These payments can take the form of dividends, share repurchases, reduction of nominal value. 5 He will also charge subscription rights. However, what he receives in subscription rights, he loses in decreased share value due to the dilution produced by the capital increase. 6 DPS is the abbreviation for dividend per share. Although we only use DPS, we are always referring to the expected dividend per share CH28-7

8 Appendix 1 shows that the share s price can be expressed in the form of the Gordon and Shapiro formula (1956): [2] P 0 = DPS 1 / (Ke g) Example. Calculate the value of a share whose annual dividend was $100 and which is expected to grow at a rate of 4% over time. The required return to this company is 10%. The dividend expected next year is $104 and the share s value is $1,733 because, applying [2]: 1,733 = 104 / ( ). Note that if we did not expect any growth in the dividend (g=0), the share s value would be $1,000: 1,000 = 100 / (0.1-0) Example. The price of the Coca-Cola share on 31 December 2000 was $ The dividend per share in 2000 was $0.68. If the required return to Coca-Cola s equity was 9.044%, the reader can see that the average expected growth of the dividends was 7.84%: $60.94 = $0.68 x / ( ) Figure 17 shows the expected dividend growth implicit in the year-end share price and the actual dividend growth of Coca-Cola. The expected growth of the dividend per share is calculated by repeating the above calculation at the end of each year. Figure 17. Coca-Cola. Expected dividend growth implicit in the year-end share price and actual dividend growth. Figure 18 compares the expected dividend growth of Coca-Cola and Pepsico. Figures 19 and 20 compare the evolution of the dividends per share of Coca-Cola and Pepsico with the earnings per share, both expressed in nominal dollars. It is seen, particularly in the case of Coca-Cola, that the DPS growth is smoother than the EPS growth. Figure 21 shows both companies market capitalization. Figure 18. Coca-Cola and Pepsico. Expected dividend growth implicit in the year-end share price. Figure 19. Evolution of the dividend and earnings per share of Coca Cola ($ per share) Figure 20. Evolution of the dividend and earnings per share of Pepsico ($ per share) CH28-8

9 Figure 21. Market value (capitalization) of Coca Cola and PepsiCo ($ million) For a comprehensive compilation of many papers published on dividends and shareholder remuneration you may see the book published by Kalay et al. (1999). S&P 500 yield CH28-9

10 Appendix 1. Derivation of the Gordon and Shapiro formula We wish to prove the following equality: P 0 = DPS 1 / (Ke g) We start with the equation [1]: [1] P 0 = DPS Ke DPS 2 (1 + Ke) DPS 3 2 (1 + Ke)... 3 If the dividends grow at an annual rate g, then: DPS 2 = DPS 1 (1 + g); DPS n = DPS 1 (1 + g) n-1 Substituting in (1): P 0 = DPS Ke DPS 1(1 + g) DPS 1 (1 + g) 2... (1 + Ke) 2 (1 + Ke) 3 Multiplying both sides of the equality by (1+g)/(1+Ke): (1 + g) P 0 (1 + Ke) = DPS 1 (1 + g) DPS 1(1 + g) 2 DPS 1 (1 + g) 3... (1 + Ke) 2 (1 + Ke) 3 (1 + Ke) 4 Subtracting the last two expressions gives: P 0 - P 0 (1+ g) / (1 + Ke) = DPS 1 / (1 + Ke) Consequently: [2] P0 = DPS1 / (Ke g) This formula can also be expressed as: P 0 = [DPS 1 / Ke] + g DPS 1 / [Ke (Ke g)] The first addend is the dividends value if they did not grow (if they were always equal to next year s dividends) and the second term is the value of the dividends growth. Appendix 2. Dividends in different stock indexes 5 years ending in January 2015 S&P 500 DAX 30 CAC 40 FTSE 100 Eurostoxx 50 DJ 30 IBEX 35 Companies that did NOT pay dividends % 15,8% 3,3% 0,0% 3,0% 2,0% 0,0% 5,7% Dividends / Price S&P500 FRCAC40 FTSE100 DJINDUS IBEX35I ,7% 3,3% 4,2% 2,8% 4,4% ,9% 3,2% 4,3% 2,8% 3,4% ,2% 3,3% 4,7% 2,6% 4,1% ,0% 3,1% 4,7% 2,1% 3,6% ,6% 2,7% 3,2% 1,8% 2,6% ,4% 2,0% 2,5% 1,7% 2,3% ,2% 2,0% 2,4% 1,6% 1,5% ,2% 1,5% 2,2% 1,4% 1,5% ,4% 2,1% 2,5% 1,8% 1,9% ,8% 2,8% 3,1% 2,1% 2,2% ,6% 3,2% 3,8% 2,4% 3,1% ,6% 3,7% 3,4% 2,1% 3,2% ,8% 2,6% 3,5% 2,3% 3,2% ,8% 2,8% 3,4% 2,4% 3,2% ,9% 2,8% 3,4% 2,3% 3,7% ,2% 4,1% 4,4% 2,9% 4,3% ,0% 4,3% 4,3% 3,3% 6,5% ,8% 4,0% 3,3% 2,7% 5,5% ,1% 4,3% 3,6% 2,7% 6,2% ,2% 4,5% 3,9% 2,8% 7,8% ,9% 3,6% 3,7% 2,5% 5,2% ,9% 3,3% 3,5% 2,3% 4,8% ,1% ,0% CH28-10

11 Some references Fama, E.F., and K.R. French (1999), Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay? Center for Research in Security Prices, Working Paper No Fisher, K., and M. Statman (2000), Cognitive Biases in Market Forecasts, Journal of Portfolio Management, Fall, pp Fuller, R.J. and C. Hsia (1984), A Simplified Common Stock Valuation Model, Financial Analysts Journal, N. 40, pp Gordon, Myron and E. Shapiro (1956), Capital Equipment Analysis: The Required Rate of Profit, Management Science, 3, October, pp Grullón, Gustavo and David Ikenberry (2000), What do we know about Stock Repurchases? Journal of Applied Corporate Finance, Volume 13, Number 1, pp Guay, W. and J. Harford (2000), The Cash-Flow Permanence and Information Content of Dividend Increases Versus Repurchases, Journal of Financial Economics, Vol. 57, Iss. 3, September. Hurley, W.J. and L.D. Johnson (1994), A Realistic Dividend Valuation Model, Financial Analysts Journal, July/August, pp Ikenberry, D, J. Lakonishok and T. Vermaelen (1994), Market Underreaction to Open Market Share Repurchases, National Bureau of Economic Research Working Paper No. W4965. Kahle, K. M. (2001), When a Buyback isn t a Buyback: Open Market Repurchases and Employee Options, Social Science Research Network (SSRN) Working Paper No Journal of Financial Economics Kalay et al. (1999), Dividend Policy: Its Impact on Firm Value, Harvard Business School Press. Yao, Yulin (1997), A Trinomial Dividend Valuation Model, The Journal of Portfolio Management, Volume 23, Number 4, Summer, pp Questions Can we consider share repurchases as part of equity cash flows? How do you interpret figures 4 and 6? How would you decide between giving $10 million as dividends or using them to buy shares? Please define: Share repurchase Please define and differentiate: Dividends. Share repurchases. Equity cash flow CH28-11