To allow for the impact of stock repurchases, the dividend yield can be replaced with “total yield,” defined as the sum of the dividend yield and the repurchase yield in the dividend discount model. The author’s analysis points to the superiority of the dividend discount model over the total yield model.
To estimate the correct expected returns, some suggest that the repurchase yield should be added to the dividend yield and the growth rate. The author shows that the impact of net buybacks will be reflected in the dividend growth rates. The dividend discount model is the correct approach to estimate expected returns even when the firm being analyzed engages in share repurchases.
How Is This Article Useful to Practitioners?
The author shows that when everything is held constant, the initiation of a repurchase program will cause the dividend payout to fall in order to finance the repurchase. The repurchase drives a wedge between the growth rate of firm aggregates (which remains constant) and the per share growth rate.
There are several problems associated with the total yield model. The author points to the difficulty of accurately calculating net repurchases because many firms repurchase shares only to reissue shares for other purposes. In addition, firms generally do not cut dividends to initiate repurchases. Hence, the current dividend yield remains unchanged. Companies appear to substitute repurchases for future growth.
The dividend growth model requires that the dividend yield and the estimated growth rate be consistent. If the repurchase program begins toward the tail end of the period over which the growth rate is calculated, then the dividend growth model will produce a biased estimate. The author suggests that in this case, an adjustment is needed in the dividend discount model.
It is logical to assume that repurchase rate increases will have a negative effect on the future growth rate of a firm, all else being equal. Whatever the impact of the net buybacks, it will be reflected in the historical growth rate of per share quantities.