Should banks repurchase their own shares? The signaling effect is the most common reason cited for repurchasing shares

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Author: Stanley Block
Date: Dec. 2010
From: Bank Accounting & Finance(Vol. 24, Issue 1)
Publisher: CCH, Inc.
Document Type: Report
Length: 2,440 words
Lexile Measure: 1400L

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In normal times banks often have excess funds to reinvest internally, pay out in dividends or repurchase their own shares. The payment of dividends puts funds in stockholders' hands while the repurchase of shares reduces the number of shares outstanding and increases earnings per share. If the price/earnings (P/E) ratio remains constant with a share repurchase, there will be an increase in value.

Although 2009 was a tough time for banks, more than 150 financial institutions repurchased their own shares. Authors Brigham and Houston state, "Buybacks help assure investors that the company is not wasting their money by investing in subpar investments." (1)

Not every banker would agree with this line of thinking. In order to determine how bankers feel about share repurchases, I surveyed those in the banking community. A three-page questionnaire was sent to the 560 banks listed in the American Bankers" Market Monitor's daily section. One hundred and thirty-seven usable responses were returned. This represents a 24.5-percent response rate. The characteristics of the respondents are shown in Exhibits 1, 2 and 3.

For those who chose not to participate in the mailed survey, a follow-up telephone call with 40 nonrespondents indicated no statistically significant difference between those that initially answered the questionnaire and those that elected not to participate.

Comparison of Stock Buybacks to Dividends

When the respondents to the survey were asked if they preferred using excess funds to repurchase stock instead of paying dividends, the answer was generally positive (as reported below). This is consistent with what is going on in the marketplace for U.S. stocks in general, in which the ratio of stock repurchases to dividends in the last 20 years has gone from 25 percent to a position of equality.

Clearly, dividends provide immediate cash to the stockholder, but share repurchases normally produce a greater opportunity for capital appreciation. The latter is true because earnings are unchanged by share repurchases, but the number of shares outstanding is reduced, thus increasing earnings per share. If the P/E ratio remains constant, the price per share will go up.

Numerical Example

Let's look at an example for Bank A in terms of paying dividends versus share repurchases (numbers are kept small for ease of understanding). In Exhibit 4, the financial information for Bank A is presented.

If the excess cash is paid out to the stockholders in the form of dividends, the stockholders will receive $2 per share ($2,000,000 excess cash/1,000,000 shares). There is an enormous amount of research on the impact of cash dividends on stock value, and the results are generally neutral. For every study that shows positive results, an equal number of studies show no impact. Of course, if the cash dividend is unexpected or represents a significant increase from the prior year, the results are more likely to be positive.

Now assume the $2 million in excess cash is used to repurchase shares. We will assume a purchase price of slightly over market value of $30 at $32 to entice participation by...

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Gale Document Number: GALE|A248093675