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Wednesday, May 4, 2011

Paying back your shareholders

Successful companies inevitably face that prospect. The only real question is how.

McKinsey Quarterly
MAY 2011 • Bin Jiang and Tim Koller


paying back shareholders article, returning versus investing excess cash, Corporate Finance
Most successful companies eventually find themselves generating more cash than they can reasonably reinvest in their businesses at attractive returns on capital. … In fact, European and US companies currently hold a total of around $2 trillion in excess cash.1
… How much cash should they return to shareholders and how much should they retain for investment and for managing volatility? When they do return cash to shareholders, how should they do so—through cash dividends or share repurchases?
Return cash—or invest it?
Some executives and board members argue that returning cash to shareholders reflects a failure of management to find enough value-creating investments. … But in most cases, simple math leaves such companies with little choice: if they have moderate growth and high returns on capital, it’s functionally impossible for them to reinvest every dollar they earn.
Consider this example: a company earning $1 billion a year in after-tax profits, with a 25 percent return on invested capital (ROIC) and projected revenue growth of 5 percent a year, needs to invest about $200 million annually2 to continue growing at the same rate. That leaves $800 million of additional cash flow available for still more investment or returning to shareholders.3 Yet finding $800 million of new value-creating investment opportunities every year is no simple task—in any sector of the economy. Furthermore, at a 25 percent ROIC, the company would need to increase its revenues by 25 percent a year to absorb all of its cash flow. It has no choice but to return a substantial amount of cash to shareholders (Exhibit 1).


  • Exhibit 1: Returning cash is inevitable.

    • Moreover, concerns about negative signals to the market are misplaced. … As many companies are currently finding, investors typically anticipate distributions to shareholders long before managers decide to undertake them, since it’s obvious that there aren’t many alternatives. …It therefore comes as little surprise that, in aggregate, US companies have returned to shareholders around 60 percent of earnings in dividends and share repurchases each year over the past 50 years (Exhibit 2)—even if some individual companies hold on to more cash than they need for operational purposes.


    • Exhibit 2: On average, US companies have returned about 60 percent of their net income to shareholders.

      • Image representing IBM as depicted in CrunchBaseImage via CrunchBaseA number of leading companies have adopted the sensible approach of regularly returning to shareholders all unneeded cash and using share repurchases to make up the difference between the total payout and dividends. … Over the five years ending in 2010, for instance, IBM generated $48 billion of cash flow from operations after capital expenditures and acquisitions and returned $56 billion to shareholders4 in dividends and share repurchases. …
        How to pay it out
        While distributions to shareholders, relative to income, have been stable for a long time, the split between dividends and share repurchases has changed significantly. Until the early 1980s, less than 10 percent of distributions involved share repurchases. Now, about 50 to 60 percent do.
        Why the shift? … Companies, especially in the United States, have conditioned investors to expect that dividends will be cut only in the most dire circumstances. … So companies are reluctant to establish a dividend level that they aren’t confident of sustaining. They opt, instead, to buy back shares.
        Some investors, too, prefer repurchases because they can then choose whether or not to participate. …
        Does it matter whether distributions take the form of dividends or share repurchases? Empirically, the answer is no. Whichever method is used, earnings multiples are essentially the same for companies when compared with others that have similar total payouts (Exhibit 3).5 Total returns to shareholders (TRS) are also the same regardless of the mix of dividends and share repurchases (Exhibit 4).6

      • Exhibit 3: Earnings multiples are not affected by the payout mix.
        • Exhibit 4: Returns to shareholders are unrelated to the payout mix.

        • Setting the right mix
          So how should a company decide between repurchases and dividends? That depends on how confident management is of future cash flows—and how much flexibility it needs.7
          Share repurchases offer companies more flexibility to hold onto cash for unexpected investment opportunities or shifts in a volatile economic environment. … Thus, managers should employ dividends only when they are certain they can continue to do so. … Share repurchases also signal confidence but offer more flexibility because they don’t create a tacit commitment to additional purchases in future years.8 … As you would expect, changing the proportion of dividends to share buybacks has no impact on a company’s valuation multiples or TRS, regardless of payout level.
          One argument for share repurchases that doesn’t hold up to scrutiny: share repurchases increase value because they increase earnings per share. … The net effect on share value is zero. Another argument for share repurchases is that companies can repurchase undervalued shares for the benefit of those shareholders who hold on to them. In theory this is correct; however, …more often than not, we see companies repurchasing shares when prices are high.
          Successful companies inevitably get around to returning cash to shareholders in some form, if only because they simply can’t reinvest their cash as fast as it accumulates. And while there’s no fundamental difference in the value of dividends when compared with share repurchases, companies need to balance their approach against the flexibility that management needs.


          About the Authors
          Bin Jiang is a consultant in McKinsey’s New York office, where Tim Koller is a partner.
          Notes
          1 “Excess cash” is defined as the amount of cash outstanding over and above operating cash, which is defined at 2 percent of revenue.
          2 Over and above replacement capital expenditures that, we’ve assumed, equal depreciation. If the company has some debt financing, it could return even more of its profits.
          3 The same basic principle applies to different companies, depending on their levels of growth and returns on capital.
          4 IBM returned $73 billion to investors and received $17 billion from issuing new shares (primarily the exercise of employee stock options), for net distributions of $56 billion. IBM could pay out more cash than it generated from operations because it also generated cash flows from divestitures, borrowing, and changes in cash balances.
          5 We also examined the value of companies by using statistical techniques and found no impact on the dividend or share repurchase mix once we adjusted for differences in total payouts, growth, and returns on invested capital.
          6 After adjusting for differences in total payout.
          7 See Marc H. Goedhart, Timothy Koller, and Werner Rehm, “Making capital structure support strategy,” mckinseyquarterly.com, February 2006.
          8 The academic research is not conclusive on whether dividend increases or share repurchases send a stronger signal to investors.
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