My question is about curriculum’s description about Cash Dividends vs. Share repurchases in Reading relating to Dividends and Share repurchases. I understand that in case of Share Repurchases, the total wealth per share (Just curious - is it fair to call this stock price?) remains unchanged because the allocated money is reinvested in the form of common capital. However, I didn’t understand why Cash Dividends reducewealth of ownership.
Example : Let’s say that I own a Google stock for $10. Moreover, let’s assume that Google announces a dividend of $1.0 per share. Does it mean that after the shares go ex-dividend, my share will be worth $9? Why so? The dividends are based on earnings. Any dividend is like extra money. Why does it change my current worth of share? I didn’t get this at all. Can someone please explain this to me?
I would really appreciate any help. Thanks in advance. I am really stuck on this. I did google this thing, but I couldn’t find anything that backs what’s in the curriculum.
A dividend isn’t like “extra money.” You’re paying out retained earnings which are a part of book equity. Further, you’re reducing an asset (cash). Retained earnings are part of a company’s value, reducing retained earnings through a dividend reduces the value of the stock, ex-dividend.
#1 - So, does it mean that if all profit is consumed as net earnings, the stock price will increase? In my example above, it would mean that Google’s stock price would be $11. Is this accurate?
#2- Is it okay to say that the new stock price after Ex-dividend date is something like:
stock price (new) = Stock price (before ex-dividend date) +/- Earnings per share. Is this correct?
#3 - I am re-reading this topic again. One of the examples in the book says that the book value of a fictitious firm, Red Inc, is $300M. It has 20M shares outstanding and the stock price is $25. Is this possible? I am not sure because the total capital raised through equity = $25*20M = $500M, which is greater than $300M, the book value of the firm. I am not sure.
Like the question mentioned, 300M is the book value of Red Inc. . The value of (25 X 20M o/s= 500M) is the market value of Red Inc. This value reflect the expectation of the market for Red Inc. i.e. how market value Red Inc.
So if you are asked about the book value per share for Red Inc. , it will be 300M/20M o/s= 15/share.
Thanks for your reply, but I am not sure. It doesn’t make sense to me. What if I disburse dividends more than book value? Will I show -ve book value? Can someone please clarify this for us?
The rest who are reading : if you could answer the other two questions, it will really help me.
If I’m able to share with you what I have learnt during my undegraduate days, I will say that in the real world; when a company declare the dividend paid, stock price ( market price) will never fall dollar for dollar basis. For example, Company ABC’s share is currently trading at $10/share. ABC announce that they will be paying $1/share; ex-dividend share price will not be $9. Why? We are not living in a perfect world, and moreoever; market price reflect investor’s expectation for firm’s shares. Investors try to infer from the actions of the firms (i.e. signalling).
Back to your question regarding company declaring dividends exceeding the book value of equity; I think companies will not do this. Why? Remember that paying out common dividends ( if we narrow the scope of our discussion to a simple capital structure where the only class of equity is common equity) is not an obligation of firm as there might be many profitable investment opportunities that will create more value for the common shareholders in the future as compare to paying out dividends to them. Recall also that we have this sustainable growth rate , g , which tell us how much earnings have been reinvested into the company. If company pay out all their earnings as dividends, it might be detrimental to the company’s financial condition in the future. Companies normally stick to a modest, stable dividend payout policy- where dividend payment is a portion of the periond’s earnings.
If I may reply in geo’s stead (subject to his corrections/addenda):
The stock price may increase or not, depending on whether earnings are sufficient to cover the shareholders’ required rate of return.
Again, not necessarily. Stock prices reflect current earnings, expectations of future earnings, changes in perceived riskiness of future earnings, investor irrationality, and so on.
This is not only possible, but common. As I mentioned above, the market price is influenced by much more than the current value of the company’s equity. Perhaps Red, Inc. is expecting revenues to exceed $100M per year for the foreseeable future.
The total capital raised through equity will be the stock price at the time it was issued times the number of shares (less any issuing expenses); that price may have been much lower than today’s stock price. (You can calculate the total capital raised through equity from the balance sheet: preferred stock at par plus common stock at par plus additional paid-in capital.)
S2000magician, thank you for your response. I have three follow-up questions in your response.
Let’s say that Red Inc, has a book value of $10M; 20M shares outstanding with stock price of $40. Now, Red Inc decides to pay cash dividend of $20M (Hence $1 per share). What will be the new stock price? Will it be $40 - $1 = $39? {I calculated this as (20M*$40 - $20M)/20M = $39}
Secondly, you have mentioned that the stock price depends on host of other factors. Will those factors compensate to a decrease in value of the stock described above? I am little bit confused: can we conclusively predict the stock price after cash dividend disbursements are made? If no, then what is the significance of the calculation we do above? If there are so many nonlinearities in the system, then as an analyst, why should I bother about calculating the new stock price? I am a bit confused. Just as supply/demand balance out automatically, I should let the stock price be taken care by the market and wait for market’s response. Right?
Thirdly, in above example, the book value will be negative. $10M - $20M = -$10M. Is this possible?
Your responses are extremely helpful. I would really appreciate your help.
Yes, the stock price will drop be $1/share – the dividend per share – on the ex-dividend date.
No, they won’t. If the stock goes ex-dividend on Thursday, then you get the dividend if you buy the stock on Wednesday, and you don’t get it if you buy the stock on Thursday; thus, on Thursday you’ll pay $1 less than on Wednesday because you get $1 less value. (In theory, because the dividend is actually paid some time later, the price should drop by the present value of the dividend; in practice, it drops by the amount of the dividend.)
All of those other forces affect the stock price equally before and after it goes ex-dividend; their affect on the drop of the price because of the dividend is zero.
Yes, it’s possible, but extremely unlikely. The covenants on the company’s debt probably wouldn’t allow it to pay such a dividend.
I have another follow-up question after reading this entire thread and mulling over my notes. Now, I get that the stock price will go down, if the company releases cash dividends. Now, given that releasing cash dividends reduce owners’ equity and assets, do you think the book value will go down? I am guessing it should. Please let us know your thoughts.
I am sorry for reopening this thread. I have another question on this Book Value vs. Market Value problem. There is one question in curriculum in which they have provided Book Value and Market Value of Debt and Equity respectively. The goal is to calculate the weights of each of these type of financial funding. Can you please explain why we use Market value, as opposed to Book Value, to calculate the weights? I would really appreciate your help and insights.
You use the market value because that’s what you’re going to get from the market.
If your stock is selling at $25/share, then if you issue 1 million new shares, you’re going to get $25 million (less floatation costs). If your bonds are selling at a YTM of 6.375%, then if you issue $50 million par in bonds it will be at a YTM of 6.375%; if the coupon is 6.00% on 10-year, semiannual pay bonds, you’re going to get $48,629,111 (less floatation costs).
Thank you S2000magician! Your insights are really awesome. Thanks for making this world of finance really engaging for me and for this community. I simply don’t know how to express my gratitude: I am out of words. I really appreciate your every single second spent in helping this community. Thank you so much.