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January – June 2019

Choosing between share repurchases and dividend payments

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By Prof Nicolene Wesson, Prof Eon Smit, Prof Martin Kidd and Prof Willie Hamman

  • June 2019
  • Tags Finance
16 minutes to read

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Dividends vs. share repurchases: which is the better option?

When a company generates a profit and accumulates retained earnings (or spare cash), it can channel the cash back into the business to fund the operation or it can return the cash to its shareholders in one of two ways – by paying dividends or by repurchasing shares. A dividend is a share of the profits that a company pays to its shareholders. A share repurchase, on the other hand, involves a company buying back shares that were previously sold in the market to members of the public. The repurchase action reduces the number of remaining shares in the market, with the result that each shareholder is left with a larger percentage ownership in the business.

The question can be asked: Which is the better method – dividends or share repurchases? It depends. Both have benefits and drawbacks; but, perhaps more importantly, companies’ individual circumstances are a key factor in whether a share repurchase is preferable to a dividend, or vice versa.

‘A share repurchase involves a company buying back shares that were previously sold in the market to members of the public.’

Share repurchases have become the globally preferred capital distribution method, with the appeal of dividends trailing somewhat behind. Not only is share repurchasing generally a more tax-efficient method of rewarding shareholders, it can also positively impact earnings per share (EPS) and the share price. Share repurchasing is a relatively new concept in South Africa, having only been given the green light in 1999. Although research on share repurchasing in South Africa is limited, there is evidence that it has become a popular pay-out method and in fact broadly mirrors the share repurchase experience of developed countries. After all, while South Africa’s economic performance has been hampered by slow growth and high unemployment, the country nevertheless has a sophisticated financial sector and a stock exchange that is comparable to those in more advanced economies.

Concerns have been expressed, however, that companies seem to be focusing on the short-term benefits of share price manipulation at the expense of the longer-term benefits to be derived from a carefully conceived investment strategy, which would contribute to more sustainable growth for the companies concerned and the economy as a whole. Studies have been conducted in different parts of the world on the determinants of choice between dividend payments and different types of share repurchase, with ownership structure, size of the distribution and share price performance emerging as particularly influential.

‘Dividends are a mechanism whereby profits are returned to all shareholders, whether they need the money or not. With share repurchasing, however, shareholders decide whether or not they wish to participate in the arrangement.’

This study set out to ascertain the most significant determinants of companies’ choice between dividend payments and share repurchases with a view to revealing whether the opportunity to manipulate the share price in the short term is the main underlying motivation. To arrive at an informed conclusion, a literature review was conducted complemented by a practical study involving the analysis of a range of dividend payments and share repurchase transactions among a sample of JSE-listed companies.

Dividends and share repurchases: unpacking the differences

Dividends are generally preferred by those shareholders who require a steady cash flow. However, they are generally subject to tax in the year in which they are paid by the company. With share repurchases, on the other hand, shareholders can generally defer paying tax on their capital gain until the sale of the shares has been concluded.

The need for a company to have sufficient cash to distribute dividends at regular intervals tends to encourage a fairly conservative approach to capitalisation. Companies that are already paying a high regular dividend are likely to distribute excess cash to shareholders via a ‘special dividend’, which does not have a prescribed pay-out date and might be infrequent. Dividends are a mechanism whereby profits are returned to all shareholders, whether they need the money or not. With share repurchasing, however, shareholders decide whether or not they wish to participate in the arrangement by accepting or rejecting the company’s share repurchase offer. In other words, they are self-selected.

‘Not only is share repurchasing generally a more tax-efficient method of rewarding shareholders, it can also positively impact earnings per share and the share price.’

One of the advantages of share repurchases is that by reducing the number of shares in the market, the earnings per share (EPS) improve, thus sending a positive message about the company’s profitability. This may boost the share price in the long run. On the flip side, share repurchasing could signal a dearth of profitable investment opportunities or suggest that the company lacks confidence in its short-term financial prospects.

The concept of a dividend is fairly straightforward, with two main types: the regular dividend and the less frequent ‘special dividend’. Share repurchasing has more variations. The most common and most cost-effective share repurchase approach is for the company to purchase shares in the ‘open market’ at the prevailing market price. This affords the company much flexibility because it can go into the market at a convenient time. Another option is to make an offer to shareholders to purchase a fixed number of shares at a fixed price (which is usually above the current market price). There is also the self-tender approach, which is similar to the fixed-price offer, except the company specifies an acceptable price range within which shareholders can indicate their willingness to sell. Finally, a company can approach specific shareholders directly and extend an offer to them exclusively to purchase their shares.

In South Africa, the two types of share repurchase are general or ‘open market’ purchases and ‘specific’ purchases, the latter comprising pro-rata fixed-price offers and specific offers directed at targeted entities.

‘Concerns have been expressed that companies seem to be focusing on the short-term benefits of share price manipulation at the expense of the longer-term benefits to be derived from a carefully conceived investment strategy.’

What determines the choice between dividends and share repurchases?

Global studies conducted on what drives the choice between dividends and share repurchases reveal some interesting trends:

  1. Shareholder heterogeneity: Companies with a high degree of diversity in shareholder valuations (that is, small companies with a small number of shareholders) prefer a fixed-price offer or a special dividend. Conversely, companies with a low degree of diversity in shareholder valuations (that is, large companies with a large number of shareholders) prefer a self-tender offer or an open market share repurchase. The former are more likely to select a pay-out method where the informational cost is low, whereas the latter are more likely to select a pay-out method that calls for more insight into the value of the shares.
  2. Agency costs: Companies with high director ownership levels and high debt are less likely to select an open market share repurchase (which could suggest a conflict of interest with general shareholders), whereas companies with low director ownership levels and low debt are more likely to prefer an open market share repurchase as it would better align directors’ interests with other shareholders’ interests.
  3. Dividend payment history: Investors who are interested in earning investment income (that is, dividends) will invest in companies that have high dividend pay-outs. However, where financial flexibility is important, companies will probably choose to use up excess cash by repurchasing shares in the open market rather than increasing dividends because if a potential investment or acquisition opportunity were to present itself, it would be less damaging to shareholder confidence if the company were to curtail a share repurchase than cut dividends.
  4. Size of distribution: In the case of small pay-outs, companies tend to choose a special dividend. However, for large pay-outs the preference is more likely to be self-tender offers followed by open market share repurchases.
  5. Level of company valuation: Where companies are significantly undervalued, their preference is for a fixed-price offer over an open market share repurchase, as it would send a reassuring signal to the market about the true value of the shares. Although special dividends could also be used to create a favourable impression of a company’s worth, share repurchases have been shown to be more effective than special dividends in boosting the share price.
  6. Share price performance: Companies whose shares are not performing well are more likely to select a fixed-price offer over an open market share repurchase, thereby mitigating the risk of a disappointing response from the market.
  7. Takeover threat: Companies facing the threat of a takeover are more likely to opt for an open market share repurchase or self-tender offer than special dividends when there is a high level of diversity in shareholder valuations. Shareholders who would be willing to tender are those with the lowest valuations, which would raise the cost of a takeover and act as a deterrent.
  8. Management share options: Companies whose management enjoys share options are more likely to repurchase shares than to pay dividends, since share repurchases will increase the value of the options that they hold and also their ownership in the company.

‘Share repurchasing could signal a dearth of profitable investment opportunities or suggest that the company lacks confidence in its short-term financial prospects.’

Global empirical evidence points to the fact that short-term share price manipulation is not the main motivating factor in selecting one or other pay-out or distribution method. Several other factors, notably those listed above, have an important role to play in the final determination.

How this study was conducted

Share repurchase data are not readily available in South Africa, which is largely attributable to JSE listing requirements. However, there is some empirical evidence to suggest that share prices generally react favourably to share repurchase announcements.

This study compiled share repurchase data by capturing (and reconciling) data mainly from disclosed annual reports. Two distribution methods were analysed in this study: open market share repurchases and special dividends. The population for the study was 94 JSE-listed companies covering 190 transactions in the period 1999-2009. A logistic regression model was applied to estimate the relationship between nine independent variables and the choice of the two distribution methods. The bulk of the statistical work was conducted using the Statistica 12 software package.

The empirical study revealed that the significant determinants of the choice between open market share repurchases and special dividends in South Africa are shareholder heterogeneity, size of the distribution and level of company undervaluation. However, undervaluation was not found to be a significant variable when disaggregated into sector and company size categories. In addition, upon disaggregation, agency cost (based on directors’ shareholding and debt levels) and history of dividend payments were found to be significant.

Among the results showing the relationship between the different variables and the two distribution methods were: smaller companies with fewer shareholders favour open market share repurchases over special dividends (in contrast to global norms); in the case of small distributions/pay-outs, open market share repurchases are preferred over special dividends (in contrast to global norms); companies that are undervalued are more likely to choose share repurchases over special dividends (in line with global norms); high directors’ ownership and debt levels are associated with open market share repurchases (in line with global norms); and companies already paying high regular dividends tend to favour special dividends (in line with global norms).

Interestingly, the two determinants that one would most closely associate with potential share price manipulation – that is, level of company undervaluation and share price performance prior to the transaction announcement date – were not found to be significant at the sector and company levels. Short-term share price manipulation, therefore, was not found to be a key determinant of the choice between share repurchases and dividend payments, and thus fears in this regard – at least in the South African context ‒ appear to be largely unfounded.

Looking ahead

Most studies on the determinants of the choice between share repurchases and dividends have focused on only one determinant or very few determinants. More expansive investigations covering more variables and a larger population would be valuable, particularly in today’s financial climate in which companies are under pressure to deliver meaningful returns on their shareholders’ investment while also upholding strict governance standards.

  • Find the original journal article here: Wesson, N., Smit, E. v. d. M., Kidd, M., & Hamman, W. D. D. (2017). Determinants of the choice between share repurchases and dividend payments. Research in International Business and Finance, 45(0), 180-196. https://doi.org/10.1016/j.ribaf.2017.07.150
  • Prof Nicolene Wesson lectures in Accounting and Taxation at the University of Stellenbosch Business School.
  • Prof Eon Smit is from the University of Stellenbosch Business School.
  • Prof Martin Kidd is from the Department of Statistics and Actuarial Sciences, Stellenbosch University.
  • Prof Willie Hamman is from the University of Stellenbosch Business School.

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