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Retained Earnings,
Stock Repurchase, and Dividends

(August 21, 2012)

Summary: When a company is profitable, the executives who run the company must decide what to do with the extra money. They can save or spend it for the good of the company (retained earnings), or they can distribute money to the shareholders via a stock repurchase or by paying dividends.

Suppose at the end of every month, you and I were fortunate enough to have a significant amount of money left over after paying our expenses. What might we do with the extra cash? We have three basic choices. We can:

1. Save it
2. Spend it
3. Give it away

In principle, companies that are profitable have the same three choices as do people. They can save the money, spend the money, or give it away. However, with a company, the situation is not nearly as simple.

To explain why, I'm going to describe the ways in which extra cash can used by a "publicly traded company", that is, a company that issues stock to the general public. This includes virtually all of the companies you know about. (If a company's stock is not offered to the public, it is referred to as a "privately held company".)

After a company pays all its expenses, whatever money is left over is referred to as "profit" or "earnings". The main goal of every company is to make as much profit as possible. If you, as a person, have extra money at the end of the month, what you do with it is your business (as long as you don't break the law). The same holds for a privately held company.

Retained Earnings

Publicly traded companies, however, must follow a large number of complicated regulations and accounting rules. Moreover, because their stocks are traded freely on the open market, such companies are watched closely by the media, by stock market analysts, and (in the U.S.) by the Securities and Exchange Commission. So whatever a publicly traded company chooses to do with its profits will, eventually, become public knowledge.

As you might expect, the people who are most interested in what a company does with its money are the owners, in this case, the shareholders. As a general rule, if a company is profitable, the shareholders will try to pressure the company into giving them some of that extra cash.

Of course, the executives who run the company have to balance all the priorities, only one of which is distributing money to shareholders. In case you ever want to be an executive of a large company, here is a list of what you might do with your profits:

1. Save Money
- Set aside cash for expected future expenses
- Set aside cash for unexpected future expenses

2. Spend Money
- Buy fixed assets (capital expenditures)
- Research and develop new tools and products
- Pay bonuses to executives and other employees
- Pay down debt
- Acquire another company
- License intellectual property, such as patent rights
- Expand the market for your products
- Make investments that, hopefully will generate a profit

When the executives use a company's profits in the ways I described above, they are using the money for the good of the company itself. Money used in this way is referred to as "retained earnings", because the money is kept by the company for its own use and not distributed to shareholders. Since the executives are responsible for making the company profitable, it is crucial that they understand how to use retained earnings wisely. Specifically, they must decide how much profit should be retained and how much should be distributed to shareholders.

Sometimes the executives of a company will choose to retain all the earnings, which means the shareholders get nothing. However, if a company is profitable year after year after year, the shareholders — as owners of the company — expect to receive some of that profit for themselves.

There are two ways in which this can happen. First, the company may use some of the money to increase the value of its shares. (I'll describe how this works in a moment.) This pleases the shareholders, of course, because the shares they already own become more valuable. Alternatively, the company may choose to distribute cash directly to the shareholders.

Stock Repurchase

Above, I summarized how a company can use retained earnings to (1) save money, or (2) spend money. To complete the summary, here are the two ways in which a company can give away some of it's profits to its shareholders:

3. Give money to shareholders
- Increase the value of existing shares
- Distribute cash directly

The most common way for a company to increase the value of its shares is to buy a large number of them on the open market and then take those shares out of circulation. This is called a "stock repurchase" or "share buyback".

Because a stock repurchase reduces the number of outstanding shares, it has the effect of raising the value of the remaining shares. If you own shares in such a company, you will find that, after the stock repurchase, your shares will go up in value.

Although a stock repurchase is profitable for shareholders, it is a relatively rare event. This is because it will only happen when the company's executives think the stock is significantly undervalued and, at the same time, the company has enough extra money to buy back a large number of shares.

Generally speaking, companies that decide to give money to shareholders will do so directly in the form of a quarterly payment. (Quarterly means every three months.) Before we get into the details, I want to digress for a moment to explain why the corporate world works in three-month cycles.

By law, publicly traded companies in the United States must balance their books every quarter by filing special forms with the Securities and Exchange Commission (SEC). At the end of each of the first three quarters of the year, the company files a quarterly report called a Form 10-Q. At the end of the fourth quarter, the company files an annual report called a Form 10-K. All such SEC reports are released to the public.

Within these reports the company must provide detailed statements, showing profit and loss for the quarter (or the year), as well as a continuing view of the company's financial position. On the day such a report is filed with the SEC, most companies will also make a public announcement in the form of a press release. In addition, large companies will usually also host a conference call with stock market analysts. During that call, the company's top executives will discuss the report in detail and answer questions.

Now you can see the reason all publicly traded companies operate on quarterly cycles: it is because of the customs and regulations that force them into organizing their operations into three-month intervals. For this reason, when companies choose to pay money directly to their shareholders, they typically do so by making cash payments every quarter.

These payments are called "dividends", and here is how it works.

Understanding Dividends

The whole process starts when the executives of a company decide to pay a dividend. They take their request to the Board of Directors for approval. (The "Board of Directors" is a small group of people who are elected by the shareholders to represent their interests. To do so, the Board chooses the CEO, the Chief Executive Officer, and oversees how he or she runs the company.) No dividends can be paid, or even announced, until the Board of Directors approve. In fact, even if the company has paid a dividend regularly, every quarter for many years, each new payment must still be approved by the Board.

On a particular day, called the "declaration date", the Board of Directors announces they will pay a dividend and specifies how much it will be. For example, the Board might announce that they intend to pay a dividend of 85 cents/share to every shareholder. If you owned, say, 1,000 shares, you would receive $850 (1000 x $0.85). The moment a dividend is announced, a liability is created, because the company now owes money to its shareholders. This liability is immediately recorded on the company's books as a future expense.

Because dividend payments require a company to divide a large amount of money into smaller pieces which are then paid to many different shareholders, the process must be organized carefully. For this reason, when a Board of Directors announces a dividend, they also announce three more dates (explained below): a payment date, a record date, and an ex-dividend date.

The "payment date" is the day on which the dividend will actually be paid to the shareholders. For example, a company may announce that, on September 10, they will pay a dividend of 85 cents/share to every shareholder.

Once a dividend is announced, the question arises: for the purposes of paying the dividend who, exactly, is a shareholder? Using our example, what if someone doesn't own any shares of the company, but they buy some just before September 10. Does that entitle them to the dividend? Conversely, what if someone does own shares, but they sell them just before September 10. Do they lose out on the dividend?

To avoid such problems, at the time of a dividend announcement the Board of Directors will also specify a "record date". Only shareholders who have shares registered with the company on that date are entitled to the dividend.

Now, when someone buys or sells shares of stock, it takes time to register the transaction with the company. When this happens, we say that the trade has "settled". In the United States, it takes three business days for stock market trades to settle. Thus, if someone wants to purchase shares of a company in order to receive an upcoming dividend, he or she must buy those shares at least three days before the record date. This is called the "in-dividend" date.

The first business day after the in-dividend date is called the "ex-dividend date". The ex-dividend date is important, because it is the first day on which shares that are bought and sold do not come with the right to receive a dividend. Although this sounds a bit complicated, it's not hard to understand when you see an example.

On July 31, 2012, the IBM Board of Directors announced that they would pay a quarterly dividend of 85 cents/share. The ex-dividend date would be August 8; the record date would be August 10; and the payment date would be September 10.

This means that, if you are registered as the owner of IBM stock on August 10 (the record date), you will receive a dividend on September 10 (the payment date). If you want to buy new shares, you must buy them before August 8 (the ex-dividend date) in order to be registered by August 10.

Two Dividend Stories: IBM and Apple

Once a company begins to pay dividends, it usually continues to do so regularly, every quarter, as long as the company remains profitable. After all, shareholders are the owners of the company, and they deserve some of the profits.

The most extreme example I know of is IBM. On April 10, 1913, IBM made their first dividend payment. This was followed by two more in the same year. There was then a break of a year and a half until April 10, 1916, when they resumed paying. To be sure, as the company's fortunes varied over the years, the value of its dividend went up and down. However, in all that time, IBM never missed a single quarterly dividend payment! Thus, with the September 10, 2012, payment I mentioned above, IBM will have paid dividends for 386 consecutive quarters (95 years).

An even more interesting dividend story is that of Apple, which for years held onto a huge amount of profit, before finally agreeing to give some of it to its shareholders. Here is how it happened.

Apple was incorporated on January 3, 1977, as a tiny, privately held company by Steve Jobs and his partner Steve Wozniak. In May 1985, Jobs was forced out of the company, and in February 1987, Wozniak left. Up to that time, Apple had never paid a dividend. Soon after Wozniak's departure, Apple's Board of Directors decided that the company was doing well enough to begin to pay a quarterly dividend. The first dividend was paid on June 15, 1987. The dividends continued, every quarter, until December 1995.

By the end of 1995, however, Apple was doing so poorly that the Board of Directors decided to stop paying a dividend. Indeed, during Apple's 1996 fiscal year (which started on October 1, 1995), Apple lost $816 million. In the 1997 fiscal year, Apple lost $1,045 million.

In July 1997, Steve Jobs was hired back by the company as interim CEO. Financially, Apple was doing so poorly that, almost immediately, Jobs announced a partnership deal with Microsoft in order to keep Apple afloat. Until then, Microsoft had been Apple's arch-enemy. With this deal, Microsoft became Apple's best friend. Jobs negotiated a deal in which Microsoft would make a five-year commitment to release Microsoft Office for the Macintosh. In addition, Microsoft would invest $150 million in Apple.

In time, Apple's fortunes improved. Nevertheless, Jobs became stubbornly reluctant to do anything with Apple's extra cash except to hoard it. It is widely believed that Jobs never again wanted Apple to be in the position of having to go hat in hand to another company to raise money (especially Microsoft!) just to stay alive.

Like someone who lived through the Great Depression and later became a miser, Apple eventually accumulated huge amounts of money which Jobs refused to spend. This is why, until Jobs' death (on October 5, 2011), it was impossible for Apple's huge store of cash to be returned to shareholders in the form of a dividend, a share buyback, or both.

However, on March 18, 2012, Apples's Board of Directors announced that the company would finally resume paying a regular quarterly dividend. At the same time, the Board also announced a $10 billion, three-year share buyback to start in October 2012. On August 16, 2012, Apple paid a dividend of $2.65/share, the first in more than 16 years.

Why was this such a huge deal? By the time the Apple Board of Directors made the announcement, the company had accumulated more than $100 billion dollars in excess profits. (Read that last sentence again.) Finally, some of Apple's wealth was going to be distributed to its shareholders.

The move by Apples' Board of Directors not only put real cash into the hands of the shareholders. It also, indirectly, benefited the shareholders in another way for two reason. First, in order to generate income, many people choose to invest in stocks that pay dividends. A lot of these people will buy Apple stock now that it has agreed to provide regular income to its shareholders. Second, many so-called "value-oriented" mutual funds are not allowed to buy stocks that do not pay dividends. Now that Apple is paying a dividend, these funds will be able to invest in the company. In the long run, more people and more mutual funds wanting to buy Apple stock will increase its value.

Dividends and Taxes

To finish our discussion, I'd like to take a moment to explain how dividends are taxed.

When you buy something that, later, you sell for more than you paid for it, the profit is considered to be a "capital gain". For example, if you buy stock (or a car or a painting or an elephant) that you sell for a profit, you have made a capital gain. In the United States, capital gains are taxed at a lower rate than income. Thus, if you have a choice, it is better to make money by buying and selling something, than it is to earn the same amount of money by working for it.

In general, dividends are classified as income, not capital gains. However, many people feel this is unfair because the company that pays the dividend must do so with after-tax dollars. In other words, the company must first pay income tax on its profits, and then use what is left over to pay for the dividend. Then the shareholders, who receive the dividend, must pay tax on it for a second time.

To mitigate the double taxing of dividends, there is a rule that allows people who have held the stock for at least two months to count dividends as capital gains instead of income. Specifically, if you hold a stock for more than 60 days, within the 120-day period surrounding the ex-dividend date, your dividends are taxed at what is called the "net capital gain rate". This rate is significantly lower rate than the regular income tax rate.

What does this mean in dollars and cents? If your regular tax rate is lower than 25%, you won't pay any tax on your dividends. If your regular tax rate is 25% or higher, you will pay only 15% tax on your dividends.

Can you see why many investors want Apple to pay a dividend? As long as they have held their stock for over 2 months, the dividends they receive will be taxed at a low rate.

More generally, can you also see why rich people use all the loopholes their accountants can find in order to classify their income as a capital gain? This allows them to pay taxes at a much lower rate than people who work for a salary.