"Newbies"

Humor

Themes & Topics

Glossary

Lecture Notes

Trivia & Factoids

IBM to Buyback $3.5 Billion Shares

News

On November 26, 1996, IBM's Board of Directors approved the company’s purchase of an additional $3.5 billion its own shares on the open market.

 Big Blue has already spent nearly $10 billion since January 1995 buying back its stock

Analysis

I would like to use this news to look at the merits of "stock repurchase" and its relationship to dividends.

Definitions and Implications of Dividend and Stock Repurchase
Dividend is a distribution of value to shareholders. Using this definition of dividend, then "stock repurchase" is just one form of dividend. Can you see the connection?

When a company buys back its own shares, it has to offer a price higher than the current stock price; otherwise investors have no incentive to sell their stock. By offering a price higher than the market’s, the company is distributing value to its existing shareholders. Note that "dividend" is used in a generic sense of value-distribution as well as a cash distribution, the most common form of dividend. You should also note that cash dividends are paid on a regular basis unless the company explicitly announces an on-time increase in dividends. The latter is referred to as a "special dividend."

The main advantage of stock repurchase over dividends is that the former is a one-time distribution. An increase in regular dividend is promised to the shareholders, such that the company would be paying the dividend on a regular basis in the future.

There are two important implications of "expected regular dividend" and "one-time distribution." One implication is that if a regular dividend is lowered, investors will interpret this act as a bad sign, and thus the price of the stock will tend to fall. Because of this built-in expectation, dividend is a burden on the company, as the company feels obligated to satisfy the expectation. On the other hand, stock repurchase is a one-time deal, and thus shareholders don’t expect it to continue in any regular fashion in the future.

Is An Increase In Dividend Good Or Bad For The Shareholders?
The answer is, it depends. Using the previously stated definition, paying dividends suggests that the company must, at least, have "excess" cash on hand. Thus, the question boils down to: what should a company do with its "excess" cash? Such a company has two alternatives: either invest the money in projects (internal expansion or acquisitions) or distribute it to shareholders. The choice between these two alternatives is simple: if the company has good projects (i.e., those with Net Present Value 0), then it should invest in these projects as they would create value to shareholders. Otherwise, the company should distribute the "excess" cash to shareholders in the form of dividends.

When a company increases its regular cash dividend, it is typically saying one of two things. One, using the "burden" argument outlined above, the company is saying (or signaling) that it expects to be profitable in the future and thus the increase in dividend is not a "burden." The second scenario, using the "good projects" argument above, is that investors may interpret the move as a signal that the company does not have profitable projects and thus it is distributing "excess" cash. Obviously, if the market believes the first argument is true for the company, stock prices tend to increase; prices decline if it believes the company is facing the second scenario.

IBM Specifics
Big Blue has been able to implement the stock buybacks because of the company’s strong inflows. Due to the surge in cash inflow, it was able to spend $3 billion to buy Lotus Development Corp., 80 million for Edmark Inc., an education software company, 5.7 billion to buy back stock, and still have nearly $8 billion in cash remaining on its balance sheet.

According to analysts’ estimates, Big Blue now generates between $6 billion and $7 billion a year, more than enough to meet its capital spending needs. Instead of going on a spending spree with its excess cash, IBM seems to be prudent in the selection of its capital budgeting projects.