2. How dividends are paid

1. Special dividend

The special dividend (or exceptional dividend) is a dividend of an exceptionally high amount compared to the ordinary dividend. It is obviously not paid on a regular basis and usually corresponds to an exceptional event within the business life of the company (disposal of a large subsidiary, end of a lawsuit, etc.). The 438p dividend from InterContinental that we mentioned in the previous chapter was an exceptional dividend.

The special dividend is sometimes the tool used by a group to dispose of an asset (LVMH of 22% of Hermès) or a branch (Kering of Fnac).

2. Share buy-backs

Only listed firms can buy their own shares back on the market. Depending on the country, the buy-backs have to be authorised by shareholders and may be limited in volume (for example, a maximum of 10% of the shares every year or 18 months) and in price (a maximum share buy-back price is set). Generally, the shares bought back will be cancelled but they can also be kept by the company (as treasury stocks) to be handed over in the case of an acquisition, for the exercise of stock options or for the conversion of convertible bonds. Treasury shares lose their voting right and their right to a dividend. They can also be used to enhance liquidity through a liquidity programme implemented by a broker.

Furthermore, share buy-backs can be used to ease the exit of a large minority shareholder. In this way, Dassault Aviation allocated part of its share buy-back programme in 2016 to Airbus.

Under US GAAP and IFRS, treasury stocks are deducted from the amount of shareholders’ equity.

3. Capital reduction

A capital reduction corresponding to a distribution of cash can be accomplished:

• By reducing the par value of all shares, thereby automatically reducing authorised capital.
• By tender offer. In practice, the board of directors, using an authorisation that must have been granted to it at an extraordinary general meeting, makes an offer to all shareholders to buy all or part of their shares at a certain price during a certain period (usually about one month). If too many shares are tendered under the offer, the company scales back all the surrender requests in proportion. If too few are tendered, it cancels the shares that are tendered. If management decides on a tender offer, it has the option of considering the traditional fixed-price offering or the Dutch auction method. In Dutch auctions, the firm no longer offers to repurchase shares at a single price, but rather announces a range of prices. Each shareholder thus must specify an acceptable selling price within the prescribed range set by the company. If he chooses a high selling price, he will increase his proceeds provided that the shares are accepted by the company, but he reduces the probability that shares will be accepted for repurchase. At the end of the offer period, the firm tabulates the received offers, and determines the lowest price that allows repurchasing the desired number of shares.
• In some countries, a share buy-back can be accomplished by issuing put warrants to each shareholder, each warrant giving the holder the right to sell one share to the company at a specified price. Such a warrant is a put option issued by the company.

A capital decrease changes the capital structure and thereby increases the risk borne by creditors. To protect the latter, the law generally allows creditors to require additional guarantees or call their loans early, although they cannot block the operation outright.

4. The impact on the company and its ratios

Consider a company with book value of equity of €400m, one million shares outstanding and earnings of €20m. Suppose that it reduces its share capital by 20% by buying back its own shares at their market value, in one case at €200 per share and in another case at €800 per share. It pays for the buy-back by borrowing at 3% after tax (or by liquidating short-term investments earning 3%, which amounts to the same thing).

After the transaction, the book value of equity has decreased by the amount of funds spent on the repurchase – €40m in one case, €160m in the other – and so has the market value. Going forward, earnings are reduced by the additional interest charges. The relevant analysis, however, is at the per-share level. The repurchase is made at the current share price (or at current value, if the company is not quoted), possibly increased by a premium of 5% or 10% to induce holders to tender their shares under the offer.

With repurchase at €200, earnings per share increase by 17.5% and decrease by 5% with repurchase at €800.

The transaction is thus the inverse of a share issue, which should come as no surprise to the reader. Bear in mind that, although the calculation of the change in earnings per share is of interest, it is not an indicator of value creation. The real issue is not whether a capital decrease will mechanically dilute earnings per share, but whether:

• the price at which the shares are repurchased is less than their estimated value;
• the increase in the debt burden will translate into better performance by management; and
• the marginal rate of return on the funds returned to shareholders by the buy-back was less than the cost of capital.

These are the three sources of value creation in a capital decrease.

We frequently see it argued that a capital decrease, by replacing a more costly form of financing (equity) with a less costly one (debt), lowers the weighted average cost of capital. The reader who has absorbed the lessons of Modigliani and Miller and understands that cost of capital is independent of capital structure (remember “the size of a pizza is the same no matter how you slice it”?) may be indulgent. To err is human; only to persist in error is diabolical!

As an illustration, here are the top 20 share buy-backs in 2016 in Europe:

1. Flexibility

It is difficult to radically and rapidly modify the dividend level. Any change in the dividend policy raises concerns about the future evolution of the business model and creates expectations regarding the medium-term sustainability of the new level of dividends. This is the major reason for which changes in the dividend policy generally occur very slowly and produce effects on the capital structure only after some periods.

Conversely, capital reductions and extraordinary dividends are specific una tantum decisions, and investors do not expect any regularity regarding them. They can perfectly fit situations where the company wants to distribute the cash generated by an important asset or intends to modify the capital structure rapidly.

Share buy-back programmes are as flexible and are appropriate for returning temporary excess cash flows to shareholders pending an increase in payout, a drop in earnings, or an increase of the company’s investment needs. Groups used such programmes frequently until 2007, before they were phased out in 2008–2009.

Besides the regular annual ordinary dividend, Bouygues returns excess cash flows in the form of share buy-backs. In 2005 when it sold its water distribution arm, given the lack of material investment opportunities, Bouygues distributed an extraordinary dividend of €1.6bn. In September 2011, the Bouygues family took the opportunity of a drop in share price to increase their stake in the capital, without investing cash, through a €1.25bn tender offer on 12% of Bouygues capital in which the family did not participate.

2. Signalling

All financial decisions send signals to investors, and thus the company must ponder the expected perception investors may have following the adoption of a specific financial decision.

Applying this principle to dividends, we can reasonably say that the most neutral solution is represented by the extraordinary dividend: it is non-recurring and it does not imply any judgement on the value of the stock. Moreover, it benefits all investors.

Changes in ordinary dividends and capital reductions, however, are clearly perceived as signals sent to the market: in the former case, regarding the level of future earnings; in the latter case, regarding the stock price because a company would not buy a portion of its shares if the management believed that the shares were overvalued.

Jagannathan et al. (2000) have demonstrated that share buy-backs give little information about future results compared to dividends. While companies that increase dividends show an improvement of results, a similar conclusion cannot be reached with share buy-backs. The distribution of dividends contains a commitment from the management to maintaining the same level of dividend (or increasing them) for a certain number of periods; share buy-backs do not imply an analogous commitment. Thus, cyclical companies are more inclined to use share buy-backs than non-cyclical companies.

3. Impact on shareholder structure

Ordinary and extraordinary dividends do not affect the shareholding structure because they do not modify the number of outstanding shares. On the contrary, capital reductions and share buy-backs affect shareholder composition because some shareholders may simply decide not to participate in the capital reduction or to sell their shares in the case of a share buy-back. Their percentage of control increases.

As an example, the share buy-backs of Dassault Aviation on 14% of its capital allowed the Dassault family to increase its stake from 50% to 59% in 2015. An increase in dividend would probably have been complex in such a cyclical sector as military and business aircrafts; a special dividend would not have allowed for an impact on shareholding.

4. Impact on stock options

According to the current legislation of some countries, the capital reduction realised by buying back shares at a high price requires an adjustment of the exercise price of the stock options with a neutral effect on stock option holders.

However, some legal systems do not regulate similar adjustments in the case of ordinary or extraordinary dividends. Since an extraordinary dividend can strongly reduce the stock price, the absence of any adjustment of the exercise price of the stock options explains why this instrument is not favoured by the management.

The strong decrease in the number of companies distributing a dividend (66% in 1978 vs. 21% in 1999) in America until early this century can also be at least partially explained by the increasing popularity of share buy-backs, probably pushed up by the managers holding stock options.

In fact, the distribution of a dividend mechanically reduces the stock price, thus decreasing the probability of a high capital gain for stock option holders. The share buy-back does not generate this negative effect on the value of the stock options. It also leaves unsophisticated investors believing that the stock price will go up.

5. Tax issues

Tax is naturally an important element that requires close attention. For individual investors belonging to the top classes of personal income, generally speaking taxation is lower on capital gains than ordinary dividends. This pushes shareholders to consider share repurchases more favourably.