ShmoopTube

00:00

Principles of finance a la shmoop share buybacks and dividends

00:06

well when companies are so profitable that they're just swimming in cashola [Company briefcase in a pool of cash]

00:11

they start to think about directly giving back some of that excess cash to

00:16

investors you know excess in quotes there now when you think about that much

00:20

cash well you have to imagine a company that sells a bottle of whatever for [man discussing company selling sauce]

00:24

eight bucks each and that bottle cost them two dollars to make and $1 to

00:28

distribute the remaining overhead and everything else cost some 50 cent so

00:32

on the back at the envelope income statement at least at a unit level looks

00:35

about like this and then they pay taxes and let's call taxes a buck fifty for

00:40

now to make the illustration easy and yeah you get three dollars in that

00:44

profit there that's pretty good so this company has three eighths or

00:47

37.5 percent net profits very high profit margin must be

00:52

great whatever in those bottles now imagine that the company not only has no

00:57

debt but it also has tons of cash on the books in fact enough cash to run the [Sauce dropping into a bottle]

01:01

company for five years at this level of expense even with no revenues they have

01:06

ample room to make acquisitions and since they pay such high tax rates well

01:11

they could borrow money really cheaply right after taxes interest on borrowed

01:14

money is deductible so it's time to consider what to do with that wonderful [Company swimming in cash]

01:18

cash hoard well generally speaking there are two ways in which that cash gets

01:23

returned to shareholders you know the people who own the company these days

01:27

are well number one share buybacks and yes companies buy back their own stock

01:31

all the time now that used to be unheard of in the 1960s and 70s because thing a [People protesting for stocks]

01:37

dividend was almost mandatory to be considered a "blue chip stock"

01:41

and in Europe share repurchase was almost tax prohibitive because the

01:45

repurchasing was taxed as if it was the company realizing a large investment

01:50

game so European companies really never bought back their own stock and kind of

01:54

still don't really today but in the US companies eat their own financial [Man with company briefcase for head eating cash at a table]

01:58

cooking and when they think their prospects for the future are good and

02:02

the market believes them to be bad as evidenced by low multiple stock prices

02:07

well, companies hold up couple of fingers and they ask the street to read

02:11

between the lines they have to announce their plans well

02:13

in advance and give dollar amounts for targeted buy back so everyone knows what

02:17

they're doing nothing sneaky here then the companies have to live under strict

02:21

rules for the buyback as well only so many shares per day per week per month [Man discussing buy back rules]

02:25

and no more than X percent of the total shares traded in a given day week month

02:29

and all that brokerages handle the trades and have all kinds of

02:33

mathematical alerts so that they don't violate any of these covenants and that

02:37

makes sense right like a company wouldn't purposely put out a bad

02:40

earnings report or at least try to to crash their stock then buy back a whole [Company share price appears]

02:44

bunch of it to have fooled the street for all the people who sold and then

02:47

feel like fools afterwards right okay well there's a simple back of the

02:50

envelope math that many companies do to frame whether or not the buyback really

02:54

makes sense although there are really no rules here that are structured but for

02:58

starters think about it this way if a company has more cash on its books and [Cash stored in a vault]

03:01

it knows what to do with and that cash is sitting in the corporate Bank of

03:05

America account earning just 1% a year while the company will ask its financial

03:09

manager, how can we do better and how much better and the financial

03:14

manager will start the answer by saying something like well our stock is at [Financal manager discussing stock]

03:18

fifteen dollars a share we have five dollars a share in cash and no debt and

03:22

business is looking good will earn a dollar...we'll stop talking like

03:26

that we'll earn dollar in cash this year

03:28

and very likely meaningfully more than a dollar a share next year and the next

03:32

like a buck twenty-five and a buck fifty I think we should be trading at twenty

03:36

five dollars a share or more... excellent answer from your wily CFO

03:41

without the weird accent their, like a surfer dude all right well at 15 bucks a

03:45

share with five bucks share in cash and no debt and no big capital expenditures

03:49

needed like a new tractor smelting factory since your current one is almost [Tractor explodes]

03:53

worn out because this one isn't... well you'd say that the equity value of your company is

03:59

ten bucks a share that is investors paying $15 share to buy your stock are

04:03

getting five dollars a share in cash and paying ten dollars a share for the

04:07

future earnings power of your company so you're gonna earn a buck a share this

04:11

year in cash meaning that it's a real dollar of cash earnings not some weird

04:16

accounting trick to pretend that it's a dollar of earnings when it's really only [Dollar appears from magicians hat]

04:20

for 30 cents or less that's one dollar of cash earnings for ten dollars of

04:24

equity value in the company well said another

04:27

way your company's equity is being valued for 10 times the cash earnings

04:33

this year if you bought back your stock at these prices while you're getting a

04:37

10 percent cash on cash return on your investment in buying your stock it's not [Man straining and explodes]

04:43

a lot to handle there go back you have already 5 bucks a share in cash you do

04:47

nothing with the cash it just sits there then next year well you'll have 6 bucks

04:51

a share maybe a tad more and the next year 7 bucks in cash and change and so

04:55

on whoop-dee-doo but if you bought back shares with all [hand takes back share]

04:58

the cash you generate this year well you'll still have 5 bucks a share in

05:02

cash which is more than ample to run your business and you'll have taken down

05:06

your total number of shares outstanding by a big number

05:09

how big a number well let's do the math well let's say you have a hundred

05:13

million shares outstanding we said you were trading at fifteen bucks a share so

05:17

you have a market capitalization of 1.5 billion and we said you had five hundred

05:22

million in cash on the books right five bucks a share times hundred million

05:26

shares that means the equity capitalization of your company is a

05:29

billion dollars in if you're gonna earn $1 a share this year well you'll earn a

05:33

hundred million dollars net of everything if you spent all hundred

05:37

million of cash earnings this year buying back stock at fifteen bucks a

05:40

share you will have bought back about six [People discussing buying back shares in meeting room]

05:43

point seven million shares well what does that mean for shareholders? well it

05:46

means that your shares outstanding will have declined from a hundred million to

05:50

a hundred minus six point seven equals ninety three point three million lots of

05:55

really good things happen when you can make this thing work

05:58

well one to earn a dollar a share you no longer need to earn a hundred million

06:03

dollars now you only need to earn ninety three point three million it's easier...Two,

06:07

the current owners still own the same company even the cash on the books

06:12

hasn't changed and you didn't dip into your cash savings to buy back stock [Cash appears in a vault]

06:15

you just used cash generated by current operations to buy back stock but now

06:21

there are fewer slices of the pie to go around pie same just thicker all right [A pie appears]

06:27

point three liquidity has declined that's a negative what does that mean

06:31

again well let's say you had only a small group of founders and investors [Founders and investors sat at a table]

06:35

who still owned a lot of stock at this point well say they collectively

06:39

owned 60% of it and none were sellers at 15 bucks a share so 60 million shares

06:44

stayed in the same hands they've always been in since the company was more or

06:48

less started you used to have 40 million shares that were traded like blackjack

06:52

cards in Vegas every day but you just bought back 6.7 million of them so now

06:58

instead of 40 million shares trading back and forth well you now have only 30

07:02

3.3 million you've just taken roughly 16.7% of the liquid shares out of the

07:09

market see that's the math right there and that's bad you want a lot of [Car pulls up at fast food drive-thru]

07:12

liquidity in your stock so the big funds can get in and get out easily all right

07:16

moving on point four well the odds of your stock appreciating probably got

07:20

better if you were just flat and earned a hundred million dollars the next year

07:25

now on a share base of just ninety three point three million shares that hundred

07:29

million dollars of net profits or net earnings turns out to be a dollar seven

07:34

a share not just a dollar if you stayed at fifteen bucks a share and still had

07:38

your 5 bucks a share in cash your price to earnings multiple just went down even

07:43

further from 10 that's the 10 bucks in equity over that dollar share earning to

07:49

now 10 over a dollar 7 in cash earnings or just nine point three times cash

07:53

earnings for the equity value of your company it's really cheap people all

07:57

right and 5 you have to believe that eventually the market will appreciate [Man discussing point 5]

07:59

your very cheap stock price and that you'll get paid for it like it'll go up

08:04

or a smart buyer will just want to buy you the whole company all right well [Person gives check for company]

08:08

either that outcome or you fire your investor relations person and remarket

08:12

the company the Wall Street with the I don't know a prettier cover on your

08:15

annual report all right well so that's share buybacks in a nutshell and that's [Nutshell cracks and buybacks appear]

08:20

one way companies return cash to shareholders and it can get all tricked

08:25

up like in the above example what if you bought back three hundred million

08:29

dollars worth of stock or what if you took out five hundred million dollars of

08:32

debt and use three hundred million of your cash so that at the end of the

08:36

buyback you've bought back eight hundred million dollars worth of stock at

08:40

fifteen bucks a share like it stayed there the whole time to reduce your

08:43

share count by eight hundred divided by fifteen equals 53.3

08:48

million to give you after that buyback 46.7

08:51

million shares outstanding right went from 100 to 93 to now 46 and change

08:57

at this point you'd have five hundred million dollars of debt and 200 million

09:01

of cash or 300 million in net debt and remember you'd have added expense to the

09:06

company in paying to rent the debt ie at five percent interest that's added an

09:10

expense of twenty five million dollars pre-tax to your costs but to earn a

09:14

dollar share at this point you only need to earn 46.7 million

09:18

dollars remember you had to earn a hundred million at the beginning and if

09:21

business just stays flat which is probably not very good but if it did and

09:25

you earned a flat hundred million dollars again well then you to earn over

09:29

$2 a share that's 100 million divided by the forty six point seven million shares

09:33

outstanding and that gives you two dollars in like 14 cents a share there

09:37

abouts okay well this is sort of the math of leveraged buyouts kind of sorta [Man discussing math of leverage buyouts]

09:42

anyway that's share buybacks and it's kind of new school, old school dividends

09:48

well historically companies felt owned by shareholders and felt obligated to [People trading stock for cash]

09:52

return cash directly to them don't necessarily act like that these days

09:56

well that was usually done in the form of quarterly dividends and the setup is

10:01

similar to the example we just went through boards would sit around a smoky

10:05

room and yeah people used to smoke a lot back in the day and note the fat load of [Man smoking a cigarette]

10:09

cash on their balance sheet while they were lighting up they look at projected

10:13

cash earnings over the next three four or five years and pick some number maybe

10:17

it was five percent of that cash earnings maybe it was 50 percent of that

10:21

cash earnings and they'd return it to the people who own the company yes the

10:25

shareholders how's that again all right the company is likely to earn 100

10:28

million dollars in cash this year after taxes the board wants to return twenty

10:32

percent or twenty million dollars to shareholders in the form of a dividend

10:36

paid quarterly that's five million dollars a quarter paid in cash in

10:40

dividends to shareholders of record of common stock and on a hundred million

10:45

shares outstanding that's a nickel a share in dividends or 20 cents in a year

10:49

if the stock was trading at fifteen bucks a share then the 20 cents over

10:53

fifteen dollars is the dividend rate get the decimal right because that's point [Dividend rate formula appears]

10:58

two over fifteen or a dividend of one point three three percent not a huge

11:04

dividend but it's a start companies love raising their dividends

11:07

and they hate cutting them notice our subtle little dig about putting after

11:12

taxes kind of here in this a weird parenthetical tone that I've got here

11:16

well why do we do that well the corporation was taxed once already

11:20

remember it earned 450 for a bottle of whatever and it paid that buck 50 a

11:25

bottle in taxes so it made the man once but who owns the corporation [Man discussing corporation taxes]

11:29

shareholders people so it was essentially they who were taxed that

11:33

first time now we come along and pay a dividend well it gets paid to the people

11:38

the people who own the company and it gets taxed again right like dividends

11:43

get taxed again like an investment gain is that fair all right well we won't get

11:47

into the politics of it but the math isn't a debate the payment of dividends

11:51

created what is essentially a double taxing of profits and a lot of people

11:56

were really not thrilled about that so they started to turn away from dividend

12:00

based stocks instead investors voted with their feet and their pocketbooks [People walking along]

12:05

and dividend paying slower growth companies ended up trading at very low

12:09

multiples hence the birth of the share buyback phenomenon but it's a digression

12:14

here we'll move on what's important is to think about dividends in context and

12:17

their inherent risks take our bottles of whatever company earning a hundred [Bottles appear on a conveyor belt]

12:21

million dollars in cash and paying 20 million in dividends well the dividends

12:24

were super easy to pay in year 1 after declaring them so wanting to be heroes

12:29

the board raised the dividend of 30 million when the company did a hundred

12:33

twenty million in cash earnings and then 40 million when the company did a

12:36

hundred forty million in cash earnings and then 60 million the following year

12:40

when the company did a hundred sixty million in cash earnings unfortunately

12:44

not a single one of the board members took this course so they didn't realize [Person watching shmoop finance course]

12:48

that sales of bottles of whatever were highly cyclical meaning that they follow

12:52

the natural boom and bust cycle of the economy where everything is great for

12:57

seven or eight years and then it blows up to smithereens and starts over well

13:01

for now don't ask why that exists will make a dartboard guesses later in this [Darts appear in a board]

13:05

course for no extra charge so now it's following year and now nobody's buying

13:08

bottles of whatever cash earnings fall to fifty million bucks but wait the

13:12

heroes on the board have already declared a dividend of 60 million [Board members sit down at table]

13:16

got it so they're earning 50 but they have a dividend obligation of 60

13:20

well that dividend is now over a hundred percent of the cash earnings of the

13:24

company in order to pay it the company has to dip into its bank account and [Bank of America cash machine appears]

13:28

take out ten million dollars for its cash horde to make people whole on the

13:33

divvy well that is not good not good at all as Winnie the Pooh said if the board

13:38

has to cut its dividend to fifty million dollars and pay out a hundred percent of

13:42

the cash earned for the year or less well the board looks stupid shareholders [Shareholder slaps face]

13:46

grouse and the board members have a hard time getting invited to join more boards

13:50

there are a lot of other problems here as well for example lots of employees

13:54

don't own shares rather employees own stock options on shares well

13:59

shareholders receive dividends option holders do not in order to receive

14:04

dividends option holders must have buy out their options to then own the shares

14:09

and they usually incur large tax bill upfront when doing so well all this

14:12

noted companies run into this kind of trouble all the time the entire oil

14:16

industry hit this snag in the mid 2010's as oil prices plummeted the good news [Man begins eating dividend]

14:20

for its dividend hungry investor base however was that the oil companies had

14:24

so much cash in such easy access to capital that they did in fact pay out

14:29

over a hundred percent of their earnings for a while to cover the dividend oil is

14:33

a well known cyclical industry managed by pros and their boards might have in

14:38

fact taken this course okay so we've covered how dividends are covered

14:42

internally and operationally inside of companies but what about how they are

14:46

received externally it's a common stock market epithet that dividends cushion [Stock drops onto a pillow]

14:51

stocks all right how well go back to one of the basic concepts that frames

14:55

investing if you put a dollar in and you want to get more than $1 out if you buy

15:00

a bond while you get a promise to be repaid the principal and you get

15:03

interest along the way if the borrower doesn't perform well then she loses her

15:08

company or her house or her jet or whatever she borrowed the money for in [Jet in the sky disappears and woman falls to the ground]

15:12

the first place right but in a stock paying a dividend there's no backup

15:15

you are a co-owner not a lender if a stock has no dividend well, you're

15:21

reliant on the value of the company going up per share to get out more than

15:25

the dollar you put in that is if you bought the stock at ten bucks a share [Company share price appears]

15:29

and it pays no dividend well you get nothing until you

15:32

sell the stock and you hope that it is selling for more than ten bucks a share

15:36

when you exit but if a stock pays a dollar a share and dividend at least

15:39

you're getting something back along the path and the time frame of your

15:42

ownership of that stock if you had a stock that paid a dollar share dividend

15:45

and stayed flat at ten bucks a share for a decade well you'd have gotten back the

15:50

ten bucks you put in originally at you know a pace a dollar a year along the

15:55

way or for that whole decade so even if the company then sold for five bucks a

15:59

share to a buyer in cash well you'd have put in ten bucks in the beginning gotten

16:04

$1 a share each year for ten years and then a final payout of five bucks or $15

16:10

total over ten years right ten dollars became fifteen over ten

16:14

years well not a great investment but at least a positive returning one recall [Hand takes cash from table]

16:18

the stickiness of dividends boards hate cutting them or removing them doing so

16:23

calls into question the viability and certainly the wisdom of the company

16:26

makes the board members look like wimps and forces investors to reconsider

16:30

whether the board is in fact doing its fiduciary duty in managing the company

16:35

so investors sort of rely on dividends remaining for long periods of time they

16:40

aren't quite as sticky as bond yields but they are sticky and investors

16:43

generally rely on them so what then happens when modestly risky bond yields

16:48

are 5% and dividend yields on a common stock approach 5%

16:53

well investors get hungry think about a company with just flat earnings but [Sloth eating a plant]

16:57

covering its dividend 2X meaning that half of its cash earnings of the company

17:02

go toward paying the dividend and the remainder is just saved and put on the

17:05

balance sheet to increment the lovely green horde of cash that's already there [Cash stored in a vault]

17:09

well that five percent yield buffers further downside in the stock like a

17:14

whole market could sell off and it's likely that stock would stay flat with

17:18

its fat 5% yield if investors are pretty certain that five percent yield will

17:22

"always" be around then at some point they will just buy the stock [Sack of cash and stock appear]

17:27

for the yield and not really care that much about whether the stock appreciates

17:30

a whole lot over time all right well tons of outside factors

17:34

affect everything prevailing interest rates have been at historic lows for a

17:39

long time in the 2000s era governments deep in debt or

17:42

praying for rampant inflation to bail them out of their financial woes and [Uncle Sam praying in a church]

17:46

they'd hook low interest rates would get him there that and prayer but well thus

17:51

far nothing has worked...

Full Transcript