Share Repurchases and Stock Valuation Models

Abstract

Share repurchases have grown rapidly in recent years and have exceeded total cash dividends since 1997. Some analysts argue that incorporating repurchases into a discounted cash flow framework leads to higher equity valuations and higher expected return estimates and, further, that traditional dividend discount models (DDMs) are obsolete. The authors disagree and demonstrate that the objection to the DDM is based on a logical error of not accurately accounting for the effect of share repurchases on investors’ future cash flows. The authors compare a traditional DDM and a correctly specified discounted total cash flow model (TCFM) to show that the valuations and rates of return are the same with both a constant-growth-type model and a more general model. Importantly, a TCFM can be used instead of, or in addition to, a DDM, and the selection of model can be based on the quality of the information applicable to a particular situation.

TOPICS: Wealth management, factor-based models, in markets