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Technology Stocks : Network Associates (NET)
NET 196.20-0.1%3:59 PM EST
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To: ROC who wrote (5378)6/20/1999 11:54:00 AM
From: Chuzzlewit  Read Replies (2) of 6021
 
ROC -- one of the misunderstandings about share repurchase is the eps issue. First the theory:

Let's assume that a company has a market capitalization of $10 BB, earnings of $500 MM with 500 MM shares outstanding. That means that the price per share is $20. Now let's assume that the company has $1 BB in cash with which it can either purchase 50 MM shares or dividend the cash to investors. If it dividends the cash to investors the capitalized value of the company will fall to $9 BB, but investors will receive $1 BB in cash -- or, if you prefer, the price per share will fall to $18, but neglecting taxes the investor's wealth is intact because he will have $2 in cash. It will still be $20.

Alternatively, the company can expend $1 BB to repurchase shares. Again the company's capitalized value falls to $9 BB, but this time the number of shares drops to 450 MM (500 - 50). The value of the company on a per share basis is still $20.

This is a situation the investor can exactly mimic by using his dividend to purchase shares. The reason that a share repurchase is preferable to a dividend reinvestment is that dividends are taxable on receipt as ordinary income, but shares repurchased become capital gains.

The boost in eps is a red herring because a company should maintain only the amount of cash it needs for operating and capital replacement requirements. Any residual cash (known as free cash flow) should either be invested at a rate higher than the firm's weighted average cost of capital or dividended out to shareholders. Put another way, the value of a firm has nothing to do with the number of shares it has outstanding. It is based on aggregate income (or cash flow if you prefer).

****

Now the practice:

Companies repurchase shares when they believe that the price of the stock is too low. That implies that their assessment of the company's prospects are different than that of the investors. This implies that the company knows something that the investor does not know and will trade on it. That smacks of self-dealing because the individual investor is at a disadvantage.

Other companies repurchase shares on an ongoing basis as a tax-advantaged dividend. This has been the practice of Dell for several years.

I apologize if I am too long winded. I hope this helps.

TTFN,
CTC
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