Does A Dividend Policy Effect A Firms Value Finance Essay

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It has been a turbulent year for industrial fastening manufacturer, Trifast. After dissatisfaction with the way the business was being managed, institutional shareholders forced its chief executive, chairman and non-executive directors to step down in March. The newly installed management team - comprising former Trifast executives - quickly instituted a strategic review and has now put together a three-year plan to return the group to profitability.

that scheme has resulted in a slew of one-off charges totalling £13.5m - these included compensation fees to former management, redundancy costs, and hits from closing underperforming sites. Indeed, it's the charges that explain the hefty loss - adjust for these and group pre-tax actually reached £2.54m. Moreover, savings made from the rationalisation efforts are expected to reach £4m a year and executive chairman Malcolm Diamond says that these benefits have already started to flow through.

The loss-making Turkish business has been sold and the new team is now renegotiating banking facilities for more favourable terms. Cash generation has improved, too, which helped net debt fall slightly in the second half. Still, the full-year dividend was axed to preserve cash - Mr Diamond says he wants Trifast to return to a progressive dividend policy once trading improves.

Arden Partners expects pre-tax profit of £0.8m for 2010, giving EPS of 0.7p (3.1p in 2008).

Dividend policy

A company's dividend policy is the company's usual practice when deciding how big a dividend payment to make.

Dividend policy may be explicitly stated, or investors may infer it from the dividend payments a company has made in the past. If a company states a dividend policy it usually takes the form of a target pay-out ratio.

If a company has not stated a dividend policy then investors will infer it. Assumptions that investors are likely to make are:

* The DPS will be maintained at at least the previous year's level (excluding special dividends) - unless dividend cover is very low or the company has warned that a dividend cut is possible

* If the payout ratio has been maintained at a roughly constant level in the past, the same will be done in the future

* Any other pattern of dividend growth will continue as long as the cover does not fall too low.

Companies do not normally increase dividends unless they are confident that the increase is sustainable. This means that increasing the dividend is a way in which the management of a company can signal investors that they are confident.

Conversely, dividend cuts are often an acknowledgement of some permanent deterioration in a company's business. Sometimes it only reflects a need to keep cash for capex. It is usually clear which it is.

dividend per share

Dividends are paid to holders of shares on the record date which will be announced beforehand by the company. More important from an investor's point of view is the ex-dividend date on, and after, which shares bought or sold on a stock exchange under normal terms will be sold without the dividend (so that the seller will get the dividend).

(so an investor, should they wish to, can buy shares on the record date, and reap a benefit from the companys efforts and succsess and receive and investor dividend even if the shares have only been in the investors portfolio for a few days.!) Clever stuff..!

Dividend irrelevance

If a company makes money, in the form of cash inflows, that money belongs to shareholders. It should not matter whether a company keeps money and invests it. or returns the money to shareholders. This is what is assumed, correctly, by most valuation methods such as free cash flow DCFs.

It is also possible to show that it should make little difference to investors whether dividends are paid or not as investors they can reproduce the cashflows of different dividend policies. For example, if a company pays out dividends, but an investor would prefer the money to be re-invested, then the investor can simply use the dividends to buy more shares.

Conversely, if a company retains too much (from a shareholder's point of view), then the share price will be boosted by the company's stronger cash position, and the shareholder can offset that by selling a few shares.

These arguments for dividend irrelevance are closely related to the Modigliani-Miller arguments for capital structure irrelevance.

However investors do often react to changes in dividend policy for a number of reasons.

One reason for paying or not paying dividends are the tax consequences. What a companies can do to minimise the ultimate tax bill (its own and shareholders' combined) will vary with tax rules and its shareholder base (different types of shareholders, such as individuals and pension funds, face different tax rules).

Tax undoubtedly has an important effect but it is far from being the whole story: companies pay dividends even under tax laws which make it always better, from that point of view, to retain the money. The simple version of dividend irrelevance also ignores transaction costs (the costs of buying and selling shares). If a company follows a dividend policy that suits them, shareholders are saved the transactions costs incurred by mimicking a different policy.

Finally, and most importantly, paying dividends sends signals to the market. Most companies' management do not like cutting dividends. This is why special dividends are used for one-off payments. Therefore, when a company pays a dividend it is showing that the management are confident that the company's earnings will always be sufficient to pay that dividend.

Returning money to investors, whether through dividends or returns of capital, also shows investors that a company is willing to return money it can not invest profitably enough to benefit shareholders. This is, of course, what companies should do but, given that many companies have wasted shareholder's money on empire building (i.e. over-expansion and acquisitions), a willingness to return money is reassuring for investors.

Although dividend irrelevance is not completely correct, it a good enough approximation to reality that fundmental valuation should usually ignore dividend policy. The signalling aspect of the more complete theory suggests that dividend yield is an important measure of management confidence, and therefore can be taken as an indicator of the stability of earnings.

Capital structure irrelevance

Simple financial theory shows that the total value of a company should not change if its capital structure does. This is known as capital structure irrelevance, or Modigliani-Miller (MM) theory. Total value is the value of all its sources of funding, this is similar to a simple (debt + equity) enterprise value.

The MM argument is simple, the total cash flows a company makes for all investors (debt holders and shareholders) are the same regardless of capital structure. Changing the capital structure does not change the total cash flows. Therefore the total value of the assets that give ownership of these cash flows should not change. The cash flows will be divided up differently so the total value of each class of security (e.g. shares and bonds) will change, but not the total of both added together.

Looking at this another way, if you wanted to buy a company free of its debt, you would have to buy the equity and buy, or pay off, the debt. Regardless of the capital structure you would end up owning the same streams of cash flows. Therefore the cost of acquiring the company free of debt should be the same regardless of capital structure.

Furthermore, it is possible for investors to mimic the effect of the company having a different capital structure. For example, if an investor would prefer a company to be more highly geared this can be simulated by buying shares and borrowing against them. An who investor would prefer the company to be less highly geared can simulate this by buying a combination of its debt and equity.

MM theory depends on simplifying assumptions such as ignoring the effects of taxes. However, it does provide a starting point that helps understand what is, and is not, relevant to why capital structure does seem to matter to an extent. The different tax treatments of debt and equity are part of the answer, as are agency problems (conflicts of interest between shareholders, debt holders and management).

There are extensions to MM theory which suggest that the actions of market forces, together with the tax treatment of debt and equity income in the hands of investors, means that for most companies the gains that can be made by adjusting capital structure will be fairly small.

Given that companies would not deliberately adopt inefficient capital structures, we can assume that all companies have roughly equivalently good capital structures - so from a valuation point of view we can reasonably assume that capital structure is irrelevant.

Using enterprise value based valuation ratios such as EV/EBITDA and EV/Sales implicitly assumes that capital structure is irrelevant.

Capital structure irrelevance is closely related to dividend irrelevance.

Special dividend

A special dividend is a dividend that is stated to be a special dividend when it is declared. The main reason for declaring a dividend special is to make it clear that it is a one-off. This is a signal to investors that it is not part of a sustainable increase in dividends.

Usually, when a company raises its dividend, the market takes this as signalling that the company will keep paying dividends at the new higher level. It may also signal a change in the company's policy regarding dividends.

Labelling a dividend "special" makes it clear that the company does not wish to signal this.

It is quite usual for a company to pay a special dividend and increase its normal dividend as well. In this case the increase to the normal dividend is a signal and can be taken as indicating the company's current dividend policy. The (usually much bigger) increase due to the special dividend is not.

For this reason the special dividend should not be included in yield calculations and has only a a limited effect on valuation.

Special dividends are most often used to return capital to shareholders.

C Investing For Income: We Want Our Dividends - Why Do So Many Shares Offer A Tiny Yield? Paddy Carter Investigates And Argues That More Companies Should Make It Policy To Return A Greater Share Of Profits To Investors


12 April 2002

By preferring growth to dividends, many investors are making a mistake that ends up leaving them worse off. Unfortunately, some companies make the same mistake themselves. More of them ought to distribute a greater proportion of their profits to shareholders and spend less cash chasing growth. If they did this, shareholders would be better served. But for this to happen, investors and company managers need to change the way they think.

Share prices - so one piece of financial theory has it - are the net present value of all future dividends, discounted for the risk that they will fail to materialise. But that makes no sense when you're looking at companies yielding 0.5 per cent. With that yield, you'd have to hang around collecting dividends for a couple of centuries before getting a return on your initial investment.

Of course, this is an oversimplified view of the world, which doesn't take into account other ways of distributing profits or the value of the shares when sold. But it does raise the question: when are all these low or no-yield companies going to start paying the dividends that supposedly justify their share prices?

A retreating yield

The average dividend yield of the total UK market has retreated, from the 5-6 per cent range during the 1970s to 2-3 per cent since the late 1990s. So less and less of the value of UK companies is being returned to shareholders in the form of dividends. Should shareholders be complaining?

Dividends seem rather out of fashion today, and firms are rarely criticised for failing to distribute profits to shareholders. Conventional wisdom says dividends should only be paid by companies with modest growth prospects, whereas higher-growth firms best serve the interest of their shareholders by ploughing all their profits back into generating more growth. But as it turns out, the dedicated pursuit of growth tends not to be in the best interest of shareholders.

The Morgan Stanley Capital International value stocks index (below) graphically illustrates that 'value' companies outperform 'growth' firms in the long run. Although the graph shows total returns, including dividend income, even the prices of value stocks have outperformed.

But how can supposedly low-growth companies actually deliver more capital growth than supposedly high-growth firms? The answer is because managers - and investors - consistently have exaggerated ideas about their company's growth prospects.

Henri Servaes, professor of economics at the London Business School, says: "There comes a time in every company's life when not every pound it earns can be reinvested so profitably." At that point, it is in shareholders' interest for the firm to return its 'surplus' money.

As they grow, companies tend to pick the low-hanging fruit first. Then they have to reach further in pursuit of growth by taking on more marginal projects, with more dubious prospects of profitability. "This is when you get a conflict between management's actions and shareholders' interest," says Professor Servaes. "Managers tend to believe they can continue to achieve earlier levels of growth."

While it is possible to expand into new high-growth markets, either organically or through acquisitions, more often than not such attempts end in failure. Just look at Marconi. The bottom line is that too many companies have an exaggerated perception of their own growth prospects and are spending money in pursuit of growth they won't achieve.

Theoretically, once it has spent what it needs to sustain its existing business, a company should calculate whether it will create more value by reinvesting surplus profits than its shareholders could by investing their dividends. If it can't, it should pay a dividend.

Overestimated returns

Firms tend to overestimate the returns they'll make from projects. But, as a proxy, the company should achieve a return on investment that at least exceeds the long-term returns of the stock market.

In their classic 1961 paper, Nobel prize-winning economists Merton Miller and Franco Modigliani demonstrated that, under a certain set of assumptions, dividend policy should be irrelevant. Briefly, their argument was: since a company's money belongs to its shareholders, dividends do no more than shuffle money around, paying investors out of their own pocket. If a firm distributes oe100m in dividends then, theoretically, the value of that company should fall by oe100m, leaving shareholders no better off.

But not all their assumptions hold true in the real world. One of Mr Miller and Mr Modigliani's assumptions was that the tax implications of receiving income or capital gains were the same. They also assumed no trading costs, and that investors and managers all have access to the same information about the company. That assumption is plainly false. Investors get their information through PR-spun corporate communications or filtered through analysts. No investor imagines they get to hear everything that goes on in the boardroom.

The disparity between information held by managers and that available to investors explains why a sudden change in dividend policy can have an immediate effect on shares. A change in dividend policy tends to be taken by investors as a signal that something in the firm's prospects has changed. With some companies, dividends are seen as a proof of virility, and a reduction is a sign that management sees troubles ahead. This is not always so.

When Royal & Sun Alliance cut its dividend last year, it did so to redirect the cash into chasing growth opportunities in the wake of the World Trade Center tragedy. The market believed what the company had to say, and its shares rose.

But more relevant to the argument here is what happens in the opposite case: when firms start to pay - or sharply increase - a dividend. Investors seem to take this as a signal the company no longer sees such good prospects for growth, and they de-rate the shares. When US technology giants Intel, Computer Associates and Compaq started paying dividends, their price/earnings ratios subsequently declined relative to their peers. Shareholders might like receiving a dividend, but they like seeing their shares fall a lot less.

Here, investors only have themselves to blame. By maintaining exaggerated expectations of growth and then punishing companies if it looks like they are changing tack in favour of more profit-sharing and less capital growth, investors are hoist with on their own petard. Although it's understandable to de-rate shares if a company's expected growth suddenly falls, it is self- defeating to force managers to pursue capital growth at all costs. After all, a steady dividend income is at least as good from the shareholder's point of view as the equivalent share price growth. Perhaps, in the wake of the internet bubble, the message that being hell-bent on growth is not so clever might worm its way into the investor's psyche.

- Sage

Sage is a prime example of a company pursuing growth at the cost of its dividend. It does pay one, which grows at a healthy rate of 10 per cent a year. But, compared with the oe84m profits after tax it reported last year, the oe5.5m it distributed as dividends is miserly.

Sage has a faultless record of delivering earnings growth. Its core accounting business has matured, though, and new customer wins have slowed. It has now turned to buying customers through acquisitions, the most significant being its recent purchase of US customer relationship software vendor Interact for $263m. That deal also brought it a new product line. Selling to existing customers requires a lot less marketing expenditure than finding new ones, so if Sage stuck with what it already has, it would need to reinvest less of its profits and could pay a higher dividend. However, it remains committed to a policy of acquisitions.

Sage has delivered on its promises so far, and its new acquisitive strategy could succeed. But there's no denying it has taken on a lot more risk in an effort to maintain growth. It would mean management abandoning the ethos which has served it so well, but its shareholders may thank it for not stretching itself too far in search of growth.

- Arm

At first glance, it might seem bizarre to ask a young high-growth company like Arm to pay a dividend. But it is already accumulating cash, at the rate of oe19m last year, and its oe104m in the bank is more of a cushion than it needs. In fact, its chief financial officer, Jonathan Brooks, is quite amenable to the idea of dividends: "The reason we're not paying one is very simple. American investors don't like them. They regard them as an indication we're going to stop growing." About a quarter of Arm's shareholders are American. And as Arm shares trade on a thumping multiple of earnings, it is essential the firm sustains its reputation as a growth business.

Also, the capital markets are effectively closed to high-tech companies. In this context, Mr Brooks want to retain as much cash as possible to fund any future acquisitions.

UK shareholders are worse off thanks to our growth-obsessed American cousins. Sooner or later, all that cash is going to burn a hole in Arm's pocket, and the temptation to splash out on a value-destroying acquisition may become overwhelming. The sooner it can convince US shareholders that it is possible to distribute some profits and maximise growth at the same time, the better.

- JD Wetherspoon

The pub operator made net profits of oe30m last year, but paid out only oe6.2m in dividends. It has delivered something like 30 per cent annual earnings growth since flotation, but like-for-like sales have started to tail off and analysts question whether it can sustain its rate of growth. Perhaps the time has come to sweat what it has for profits and share the bounty with investors.

Finance director Jim Clarke says that time is a long way off. Wetherspoons has identified over 900 potential new sites, and plans to roll out new pubs at a rate of 90 a year. Mr Clarke employs the same strict investment criteria he has always used to ensure adequate returns - and the same goes for money spent on existing pubs: "We're not spending money on anything we don't understand." The group's cash return on cash capital employed has held steady at 14.5 per cent.

As JD Wetherspoon grows, the money it needs to fund 90 openings a year will take up an ever smaller proportion of its profits. Its dividend ought to grow by a corresponding amount. The crunch will come if it finds returns starting to slip. Shareholders should hope it hasn't become so attached to its growth strategy that it would throw money at chasing it.

- Aegis

The media-buying group is in the depths of a cyclical downturn at the moment, so it might seem unreasonable to demand a higher dividend. But, even when times were good, it has been a low payer. In 2000, it made oe47.5m profit after tax and distributed oe12.5m as dividends.

Aegis is in something of a bind because investors still expect media groups to be high-growth, after the exceptional internet-fuelled years leading up to 2000. They may punish Aegis shares if they interpret a change in dividend policy as signalling lower growth. But the advertising market is mature and competitive, and a change of tack would be sensible.

Aegis does have a growth story to invest in, thanks to the consolidation of media-buying accounts from large advertisers on a global basis. It has also gained a lot of market share by being aggressive with its rates. But on average, it takes new accounts two or three years to break even, say analysts, longer than at its rivals. The company itself denies this.

It's time for Aegis to slow down. The media sector faces years of more modest progress and the risk of price deflation. Rather than going hell-for-leather for growth, Aegis should concentrate more on profitability, and let shareholders reap the benefits through a handsome dividend policy.

Ones to watch

- British Telecom

BT suspended its dividend to ease its debt problem, but now, after spinning- off its mobile arm, it has promised to reinstate it. Investors will hope, BT has learnt its lesson about aggressively pursuing growth. God forbid it gets any ideas about investing in broadcasting media over ADSL (broadband internet). Instead, it should roll out broadband at a rate that matches demand, and leave the content to partners. A nice fat dividend please.

- Carphone Warehouse

Carphone Warehouse is an example of a company that might have been better off pursuing growth less aggressively and paying a dividend. In 2000, it made oe35m after taxes, but paid no dividend. Instead, it funded expansion into Germany, which has backfired with cash losses of oe5m at the interim stage. The recently-announced restructuring, costing oe70m to shut 89 stores, graphically illustrates that its money could have been better spent. Now the company is investing heavily in providing customer care services for operators. Shareholders can only hope this latest strategy pays off. The European mobile market is mature and, although next-generation networks should breathe life back into it, Carphone must avoid repeating past mistakes. It should distribute some profits rather than pushing too hard for growth.

- Fitness First

Fitness First is a business that sees itself as still very much in the growth phase. In fact, it has just completed a oe75m placing and open offer to raise funds for more expansion. The group is highly profitable, but it doesn't make enough to fund planned capital expenditure. Chief executive Mike Balfour estimates that time will come in about four years, at which point he will look at returning cash to shareholders. Health clubs are widely acknowledged as a high-growth market. The risk is that too many companies are trying to capture it. Fitness First should not be shy of admitting if it has overestimated available opportunities, should that become apparent, and give some cash back.

- BSkyB

BSkyB has, by its own boast, passed the 'inflection point' when investment starts paying-off and the profits start rolling in. It spent billions on grabbing digital subscribers and dominating the UK pay-TV market, and is now driving up revenues per user while driving costs down. The company still has a colossal debt pile to work its way through, but the time is approaching when it ought to reward the investors who backed it with a share in the profits. Thankfully, comments made at its recent interim results indicate a dividend could be in the offing before too long.

Griffins write up

The trade off between retained earnings and paying out cash (or conceivably issuing new shares). How the corporation makes returns to its owners- there are practical, legal and taxation implications to each method. In addition to the pay/don't pay dividend decision, there is also the issue of share repurchases - an alternative way to make returns to shareholders. Also, issuing stock to fund dividends. Dividend policy in this regard is tied into the issue/repurchase of stock.

Forms of dividends

Regular cash payments

Extra/special dividends (one off supplementary payment)

Liquidating dividends (company voluntarily closes up shop, and pays shareholders back their equity

Stock dividends (payment in the form of more stock

Many companies also offer shareholders then opportunity to use their dividends to fund purchase of additional shares - why tax advantageous.

Corporate finance - perfect market view

The perfect market view (MM, 1961) concludes that dividend policy does not matter. That is, a firms value is insensitive to its dividend policy.

To examine dividend policy. We have to hold capital budgeting and capital structure decisions constant. As noted above, pure dividend policy decision involves only trade-off between retained earnings on one hand and selling new shares to obtain the cash on the other.

In this environment, dividend policy cannot affect the wealth of a firms existing shareholdings. Money is simply transferred from one form to another. AS long as this transfer is in a fair market transaction in a capital market environment, the value is the same.

A company should never give up a positive NPV project to increase a dividend (or to pay a dividend for the first time)

Bird in the hand fallacy

Are current dividends less risky than future capital gains?

Difference between the dividend now and future gains is , of coarse, risk and the time value of money

Because of the risk-return trade off, if investors want dividend now, they must accept a lower return in those shares

By holding everything constant , paying dividend does not alter the firms risk profile. Thus , risk differences do not affect value

Implications of pmv

Managers cannot change stock prics by manipulating dividend policy, and investors can undo any managerial dividend policy themselves.

Capital market imperfections

Perfect market view leaves out taxes, transaction costs and information asymmetries

Tax differential view

Argues that investors prefere capital gains over dividends(and hence low payout ratios) because capital gains are effectively taxed a lower rate than dividends.

Some empirical evidence exists to support this hypothisis, as high-yeilding stocks appear to have lower relative prices and to offer higher (pre-tax) returns.

However, transaction costs (particulary for small blocks) to create home-made dividend may offset the tax gain, as investors who want liquidity and who face large transaction costs may still be better off with the dividend.

Also, tax exempt individuals and institutions who want (or need) liquidity will prefere dividends as long as transations are not costless.

There also exists classes of investors who for legal reasons prefere firms with a history of dividend payments or high payout ratios. For example , certain funds are prohibited by law from investing in non-dividend shares or trust/endowment funds where capital gains cannot be distributed.

This gives rise to the clientele effect

This lessens perhaps eliminates the rationale for the tax differential view, in that there are two different clienteles