In this weekly series, accounting professors Jim and Kay Stice break down essential accounting and finance concepts into bite-sized chunks that are easy to understand. Tune in every Monday for a new tip.
- A corporation is a business owned by many different owners, called shareholders. The documents that prove their ownership are called shares, or shares of stock. Successful corporations generate surplus cash that they don't need for expansion or to repay bank loans. These surplus cash flows are sometimes called free cash flows. Who owns that surplus cash? Well, the shareholders do. It's wrong to think of that surplus cash as belonging to the corporation. The corporation is simply the legal ownership structure used by the people that really own the business.
The shareholders. Because the corporation doesn't need this surplus cash to proceed with its planned expansion efforts, the cash should be returned to the owners, the shareholders to use in whatever way they see fit. After all, the surplus cash belongs to the shareholders. Now, there are two ways in which surplus cash can be returned to the shareholders. The most common way is through the payment of cash dividends. Cash dividends are simply payments of surplus cash to the shareholder owners in proportion to the number of shares they own.
For example, in the 12 months into June 30th, 2016, Microsoft paid cash dividends totalling $11.3 billion. This represented a dividend of $1.39 per share for each one of the eight billion shares of Microsoft stock that were out. So, a person who owned 100 shares of Microsoft received cash dividends of $139 during that 12 month period. Good companies make a strong effort to keep consistent, slow rising dividends.
A stable dividend cash flow stream gives the shareholders and potential shareholders the impression of stability. Microsoft dividends were $9.3 billion in 2014, increasing to $10.1 billion in 2015, and then up again to $11.3 billion in 2016. The reassurance of the steadily increasing dividend payments help distract the investors from worrying too much about the roller coaster net income during the same period.
$22.1 billion in 2014. Plummeting to $12.2 billion in 2015, and then partially recovering to $16.6 billion in 2016. In summary, companies that pay cash dividends tend to pay steady dividends that almost never decrease, and that are increased only slowly and cautiously to make sure that an increased level of dividends can be maintained in the future. In addition to paying cash dividends, the second way for a corporation to distribute surplus cash to shareholders is through stock repurchases.
In a stock repurchase, the corporation, meaning the collective group of shareholders and owners, buys back the ownership shares of some of the shareholders. In essence, a small subset of shareholders take some of the surplus cash in exchange for relinquishing their ownership rights. For example, in 2014 Microsoft used $5 billion to buy back shares. The amounts were $10.7 billion in 2015, and $12.3 billion in 2016. In the notes to its financial statements, Microsoft states the following about the share repurchases.
On September 16, 2013, our Board of Directors approved a share repurchase program authorizing up to $40 billion in share repurchases. The share repurchase program became effective on October 1st, 2013, has no expiration date, and may be suspended or discontinued at any time without notice. Notice the difference between cash dividends and share repurchases. The dividend payments are almost always continued and become, in essence, self imposed corporate commitments almost as binding as interest payments.
In contrast, share repurchases, to use Microsoft's words, may be suspended or discontinued at any time without notice. The benefit to those shareholders who sell their shares back to the corporation is that they now have cash in exchange. The benefit to those remaining owners who don't sell back their shares is that they now own a higher percentage of the company because their former co-owners have taken the cash and left. So, cash dividends and share repurchases are both ways that cash is distributed to owners, but there's some interesting economic differences between these two ways of distributing surplus cash.
First, there is a strong expectation that cash dividends will be maintained at the current, or perhaps a higher level in the future. In contrast, the amount spent to buy back shares routinely fluctuates up and down. A second difference is that the set of recipients of the surplus cash are different when the cash is paid out as dividends compared to when it's paid out in the form of share repurchases. With cash dividends, the surplus cash is spread evenly among the existing shareholders in proportion to the number of shares they own.
But, with stock repurchases, the surplus cash goes to only a subset of the shareholders, and it's not a random subset. The least optimistic shareholders are the ones most likely to take the opportunity to sell their shares back and take the cash. So, another way to view share repurchases is a way for the board of directors of a corporation to weed out the skeptical shareholders, and concentrate ownership in the hands of the those shareholders most optimistic about the future of the company. Cash dividends and share repurchases, two ways to distribute surplus cash to shareholders.
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