Principles of Corporate Finance_ 12th Edition

418 Part Five Payout Policy and Capital Structure

bre44380_ch16_410-435.indd 418 10/05/15 01:41 PM

Stock Repurchases and DCF Models of Share Price

Our example looked at a one-time choice between a cash dividend and repurchase program.

In practice a company that pays a dividend today also makes an implicit promise to continue

paying dividends in later years, smoothing the dividends and increasing them gradually as

earnings grow. Repurchases are not smoothed in the same way as dividends. For example,

when oil prices tumbled in 2014, Chevron announced that it was scrapping its stock repur-

chase program for 2015. The company compared repurchases to a “flywheel” that can store or

disperse energy as needed. At the same time that it cut its repurchases, the company stressed

that maintaining its current dividend remained “the highest priority.”

A repurchase program reduces the number of outstanding shares and increases earnings

and dividends per share. Thus we should pause and consider what repurchases imply for the

DCF dividend-discount models that we derived and applied in Chapter 4. These models say

that stock price equals the PV of future dividends per share. How do we apply these models

when the number of shares is changing?

When repurchases are important, you should consider two valuation approaches for com-

mon stocks.

1. Calculate market capitalization (the aggregate value of all shares) by forecasting and
   discounting the free cash flow paid out to shareholders. Then calculate price per share
   by dividing market capitalization by the number of shares currently outstanding. With
   this approach, you don’t have to worry about how payout of free cash flow is split
   between dividends and repurchases.


2. Calculate the present value of dividends per share, taking account of the increased
   growth rate of dividends per share caused by the declining number of shares resulting
   from the repurchases.
   The first valuation approach, which focuses on the total free cash flow available for payout to
   shareholders, is easier and more reliable when future repurchases are erratic or unpredictable.
   We illustrate by continuing the Rational Demiconductor example. Suppose that Rational
   has just paid a cash dividend of $1 per share, reducing ex-dividend market capitalization
   to $10 million. We now reveal the source of Rational’s equity value. Its operations are
   expected to generate a level, perpetual stream of earnings and free cash flow (FCF) of
   $1  million per year (no forecasted growth or decline). The cost of capital is r  =  .10, or
   10%. Thus the market capitalization of all of Rational’s currently outstanding shares is
   PV = FCF/r = 1/.10 = $10 million.

Rational Demiconductor Balance Sheet

(Market Values Ex Dividend in Year 0, $ millions)

Surplus cash $ 0 $ 0 Debt

PV of free cash flow, $1 million

per year starting in year 1

10.0 10.0 Equity market capitalization

(1 million shares at $10)

$10.0 $10.0

The price per share equals market capitalization divided by the shares currently outstanding:

$10 million divided by 1 million = $10 per share. This is the first valuation approach.

The second approach requires an assumption about future payout policy. Life is easy if

Rational commits to dividends only, no repurchases. In that case, the forecasted dividend

stream is level and perpetual at $1 per share. We can use the constant-growth DCF model with

a growth rate g = 0. Share price is

PV = _____DIV

r − g

= ______^1

.10 − 0

= $10

BEYOND THE PAGE

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Repurchases

and the dividend

discount model