Assessed Blog 5 - Dividend policy: Keep your head to keep ahead

Dividend policies are somewhat influenced by investment and financing decisions. Organisations that attain a realised profit encounter the trade-off of injecting the surplus cash they have into future investments or into the pockets of their shareholders.

Both of these outlets have very fair justifications; a company needs to continue to invest in its operations to innovate or expand in its marketplace and ultimately improve its competitiveness, whereas shareholders are an integral aspect of an organisation’s funding and essentially are ‘owners’ and therefore deserve a return for their investments. The underlying issue for most businesses, however, is to adopt a policy which strikes an optimum balance between these options – if one even exists. This issue exists because organisations fear a dividend policy which does not reflect the expectations of its shareholders can prove detrimental to the company’s share price, and consequently, value.

Modigliani and Millar (1961) first noted that share prices were determined by future earning potential and not dividends paid “now”. They proposed a rational investor, an investor who is indifferent to capital gains and dividends. However, this study was based on idealistic scenario conditions where there are no taxes, no transaction costs, all interest rates are the same and all investors have free access to all relevant information (Brennan, 1971). These are clearly scenarios which modern day managers cannot operate within and are therefore irrelevant towards their dividend policy, which leads me to agree with Watts' (1973) proposal that dividend payments are most definitely an indicator of company performance.

Furthermore, I am slightly sceptical that stock markets are entirely filled “rational” investors. Although, I do acknowledge an abundance of highly-trained and qualified fund managers make up a significant portion of stock market trade, the markets can still potentially be influenced by everyday stock traders looking for a “quick buck” and who are overly anxious to shift their investment decisions at the slightest hint of uncertainty or hunch.

It is in human nature to fear uncertainty and even businesses need to conform to the vulnerabilities of human psychology. Market uncertainty can become apparent when investors are unsure of their company’s future operations.

Consider the following discussion:

Company A discovers a novel project which could substantially improve its competitive sustainability and provide an attractive NPV. The company must utilise its cash deposit to undertake this investment before it direct competitors gain first-mover advantage. Consequently, Company A lowers its dividend pay-out to provide additional investment funding but keeps the reasoning for this manoeuvre confidential so competitors are not exposed to the exclusive information.

Perhaps this news is not revealed because companies do not want to disclose too much of their strategic intentions as competitors will become aware; therefore, the longer they can keep project information confidential, the more effective and successful their strategy will be, possibly achieving greater NPVs on projects. This is a hypothetical scenario, but a feasible one which could subsequently lead to lowering share price, thus undervaluing of a company, simply as a result of shareholders feeling uncertain.

I will try to exemplify this discussion in relation to the real world:

In February, South African petrochemicals giant, Sasol, lowered its dividend policy in response to the lowering oil price; however the day after this news release on February 17^th, share prices dropped 5.12% (Figure 1) as this evidently induced shareholder fear. Sasol themselves stated the reduction in dividend will allow the company to manage cash flexibly within its balance sheet, ultimately allowing the company to execute its growth strategy whilst continuing to return value to its shareholders to some extent.

Figure 1: Sasol Share Price February 1^st – February 27th

 

Source: Google Finance, 2015

Upon seeing this news and the market reaction, other petroleum companies have more recently either chosen to maximise their dividend policies (Exxon) or maintain them (BP, Shell, and Chevron). These companies face the exact same volatile industry as Sasol, but have perhaps gauged the market reaction towards Sasol’s dividend policy change and opted to signal greater confidence to its investors. For example, Exxon stated in early April that the company was increasing its dividend pay-out and Figure 2 provides evidence to suggest the market responded positively to the news. However, this may not be the best strategic move for Exxon’s sustainability. The company recently fell behind Shell as top revenue in the industry and has also invested less capital into its operations over the past four years. It is debatable to suggest this policy is best for Exxon’s long-term position and returns, but only time will tell.

Figure 2: Exxon Share Price March 20^th – April 20^th

 

Source: Google Finance, 2015

Here we can see an evident difference between the shareholder response towards companies utilising a high pay-out dividend policy and a fluctuating dividend policy. This example potentially provides support for the “bird in the hand” argument (Lintner, 1956), as shareholders respond more positively towards short-term dividend payments, as opposed to future gains. It also suggests that even if a company is not fully convinced internally its future performance will match up to previous standards, playing it cool and reassuring investors with steady dividend payments is the first step to take to control any sporadic market fears.

The question posed: is this method suitable for a company to take if it craves for long-term success?

Assessed Blog 4 - Company Valuation: Art, chaos, or chaotic art?

It is hard to play down the importance of business valuation, even more so after acknowledging Warren Buffett as one of the discipline’s key endorsers. Buffet states “if business schools could offer just one course” it should be the “critically important” business valuation.

There are numerous reasons for business owners to require a valuation of their company: takeover or acquisition; resolving a shareholder dispute; business planning and future decision-making; the list goes on (and on, and on…). However, what is clear about company valuations, if we interpret Buffett’s statement, is that there is currently not enough expertise within the discipline on offer in the marketplace. In addition to this, no expert has come out and revealed a universal method which is most effective in providing an accurate company valuation; a) because it is a valuable unique weapon for themselves to utilise, or much more likely b) because this method simply does not exist yet (or will never exist).

Another look at William Hill and 888

As showcased in my Blog ‘Mergers and Acquisitions: Worth a punt?’ we can see the heavy bearing valuation has during takeover negotiations, and so very often, plays the ultimate deal-breaker role. In the case of William Hill (WH) and 888, the target company (888) valued itself at a substantially higher level than William Hill was prepared to pay, purely because of the difference in opinion of price between WH and a key stakeholder at 888.

We can be certain of why this deal collapsed, but we cannot be certain of how each company/stakeholder valued the target; although William Hill’s assessment may be a little easier to deduce than the key stakeholder - who ultimately rejected the offering. It is very unlikely William Hill used a Net Asset Valuation as this process looks at the historical costs available, whilst ignoring intangible, future profits and growth and hides the values of possibly a company’s greatest asset (Lo & Lys, 2000) - which this blog will look into next. 888 was/is operating in a relatively healthy state, quashing the need for NAVs greatest aspect, which weighs up current asset values in the hope that the buyer can then sell these assets at a profit; this does not align to WH’s aim of the purchase which would have been to utilise 888’s assets and merge them in WH’s infrastructure, providing the company with a greater competitive edge in the betting industry (Gugler et al., 2003).

WH’s offer appeared to lean more towards a Stock Market valuation compounded with an Income Based Valuation. I believe this because WH apparently acknowledged the market capitalisation of 888, and appreciated the target possesses the ability to grow in size and perhaps subsequently increase its profits also (Plenborg, 2002). WH will have assumed most of 888’s shareholders were aware of this future potential income and concluded that they had to offer a proportionally more enticing offer to lure the approval of all 888’s shareholders. This clearly still was not enough to attract full backing.

In contrast, it is difficult to assess 888’s, and particularly the company’s majority shareholders (founders), valuation of the target. WH concluded with an offering which significantly exceeded 888’s Stock Market Valuation; however this shareholder wanted another 50% increase in payment on top of that. I myself cannot see the logic in such a ridiculous increase on an already lucrative offer, although I do not have all the information that the 888 founding shareholders have, which in itself can suggest a semi-strong efficient market (Fama, 1970). What can possibly be assumed is that these shareholders, being founders of 888, may have their judgement slightly obscured by an emotional attachment towards their company, which they have nurtured like a child. These unjustified and emotionally-powered valuations can be seen in everyday business activities, whether it is someone is selling a treasured piece of memorabilia in a pawn shop, or a candidate on Dragon’s Den offering painfully low equity on their business idea. As shown in my earlier blog, it was evident that the market did not reflect the views expressed by these owners (Savage, 2015). Who is to say some top shareholders in the world don’t also suffer from this glazed perception of valuation? Not me.

How do you value what you cannot see?

Coming back to when I mentioned valuing “possibly a company’s greatest asset”, I will briefly discuss the critical nature of valuing intangible assets. This is arguably (or perhaps not so arguably) THE most difficult aspect during a valuation process, depending on the company involved (Garcia, 2003).

Intangible assets can fall under numerous titles including brand, goodwill, and workforce (etc.). Some have argued the process of valuing of intangible assets does not differ too much from the valuation of tangible assets and suggest the Income Based Valuation method is an appropriate method; simply assess the projected future earnings attributed to the intangible asset over its useful life whilst discounting it to its net present value. Now this process may be slightly easier when handling with internal information and knowledge. We have seen in previous cases the devastation caused by external valuations influenced by intangible assets; for example, Time Warner’s merger with AOL, Time Warner recognised the huge potential and value of AOL, but failed to recognise the enormous contrast in AOL’s young, aggressive and overly-confident workforce. This intangible asset was what driven AOL to become so successful independently, but was repulsed by integrating smoothly with Time Warner’s formal, professional and traditional workforce; this huge culture contrast played a detrimental part in the mergers catastrophic failure (McGrath, 2015).

In my opinion, this example shows that sometimes in order to make an acquisition which is influenced by intangible valuations successful, rather unconventional methods may need to be undertaken to assure correct valuations. For example, don’t simply leave valuations to, as Warren Buffett phrases so elegantly, “geeks bearing formulas”. Perhaps sometimes, a deeper investigation is needed to assess the value of an intangible asset; maybe Time Warner could have evaluated the AOL workforce it had paid to work with before realising they were arrogant children in comparison to the veterans at Time Warner, maybe this would have saved a whole lot of money and sleepless nights for dozens of executives? Additionally, when purchasing another intangible asset like a brand, as we have seen Shop Direct do with Woolworths, maybe try not to solely throw income based formulas at it? I appreciate this method will provide great substance towards putting a price tag on the asset in question, but perhaps maybe go out into your current markets, your target markets, and assess what customers think of the brand; how customers value the brand. Is throwing an (arguably) mathematically sound figure at an intangible asset definitely going to translate into customer expansion, operational efficiency, or improved cash flows?

But there we are, I am young(ish), potentially very naïve, and obviously quite sceptical of leaving business interaction solely down to men in suits with calculators and dreams of big earnings.

Assessed Blog 3 - Mergers & Acquisitions: Worth a punt?

Mergers and acquisitions are a fascinating concept when related to shareholder wealth maximisation. In some cases for shareholders, the negotiations for a merger or acquisition (M & A) can leave their stake in the company balanced on a knife-edge; this can be the case for both the buying and selling shareholders. The clear aim for most businesses is to create wealth maximisation for their shareholders (Martynova & Renneboog, 2008), which begs the questions:

          1) Why is the company targeting a specific M/A?
         2) How wil the M/A maximise the wealth of a company's shareholders?

Recently, there was extensive media coverage of William Hill’s speculated takeover bid for 888 Holdings plc. News of negotiations broke in the news on 10^th February 2015, yet the deal was ultimately quashed just six days later.

Of course, in theory, there are numerous significant benefits M & As can provide to the buying company, and consequently the respective shareholders.  It is well discussed throughout academia that M & As can generate cost efficiency through economies of scale, enhance revenue and expansion due to greater market share, and ultimately improve value generation. On paper these possibilities appear all well and good, but in reality, many shareholders and experts reserve their scepticisms of M & As.

As the UK’s largest listed betting operator, William Hill spotted the need to add new customers and boost its growth as the betting industry has been hit by new taxes and regulations from the UK government. A horizontal merge arguably was the best strategy for William Hill as it would allow synergy of the companies to take place more rapidly and ultimately improve the operations of the firm. 888 Holdings are well regarded within the betting industry for their leading technological platform; this may have drastically improved William Hill’s reach within the market, and could have provided the company with great potential for expansion.

But then again, these points are a lovely collection of “if’s, but’s, and maybe’s” which now we will never know, unless William Hill decide to really flaunt their chequebook. There are many difficult obstacles to overcome in order to achieve the positives of a M/A, and given the bawdy, aggressive and strongly-opinionated characters within the betting industry, perhaps these are two working cultures that may not integrate together smoothly.

In the process of these negotiations, there is a set of stakeholders for each company who should be strongly considered during any decision, and that is the shareholder. Shareholders of the acquiring company can suffer from a torrid time during an M & A, and in many cases, they do not want a deal to be completed.

Warren Buffet argues that company leaders and directors can be sucked into unnecessary M & As due their overly-sized ego, whilst John Kay supports this notion and suggests that managers purely love “the chase” of an acquisition. Neither of these statements provides a common shareholder with full faith in the CEO of their respective stake, and empirical studies reinforce that perhaps shareholders of the buying company (in this case William Hill) should be afraid.

Figure 1: 888 Holdings share price 2nd Feb - 16th March 2015

Hargreaves Lansdown, 2015

Jensen & Ruback’s (1983) seminal study found that the set of shareholders who really benefit from an M & A are the ‘target’ company’s; these shareholders, on average, can see an average return of 20-30% on their share value. The media tells us that William Hill offered 200p a share for 888 which – on the 9^th February – looked to be around 37% greater than the actual share price (146p; see Figure 1). However, upon the leak of the news (10^th February), 888 shares seen a monumental spike, which perhaps was caused by traders attempting to exploit greater future growth in the share value. This movement also suggests the market efficiency was semi-strong as tarders were not aware of this information until it was publicised by media leak, and then reacted appropriately to how they felt the company could be valued post-acquisition (Fama, 1970).

Regardless of the definite cause of the market’s reaction to each company’s share value, Jensen & Ruback’s finding, for the larger part, are supported by this market reaction to the information of a takeover (see Figure 2). It is clear that there is a significant increase in 888’s share value, whereas William Hill’s share price takes a slight decrease, possibly highlighting the fears created by Buffet and Kay. It can then be seen (Figure 2 & Figure 3) that upon the announcement of the deals collapse on February 16^th, that William Hill’s share price begins to rise again and ultimately reach a level greater than that before the takeover proposal.

Figure 2: William Hill share price vs 888 share price

Hargreaves Lansdown, 2015

Perhaps the hubris amongst William Hill’s leadership team was not great enough to be sucked into this chase, or maybe 888’s hubris was too much for a deal to take place; the company’s founding investors were rumoured to be holding out for 300p a share – creating a valuation gap of around £350m between William Hill and 888 Holdings.

Figure 3: William Hill share price

Hargreaves Lansdown, 2015

In this case, it could be suggested that the egos of the target company have outweighed that of the acquisitioning company. Roll (1986) infers that if a target company's share price falls after they have rejected an acquirer's offer, then it suggests that hubris has inflicted the decision-making process as the market does not agree with the decision made (see Figure 2). Conclusively, it could be argued that 888’s founding investors may have damaged value creation of their shareholders (and indeed themselves).



Assessed Blog 2 - Petrobras: Riding the pipeline of Capital Structure to Value Destruction

‘Capital structure’ is an element of Corporate Finance which receives less glamourous recognition in today’s mainstream media; it may not necessarily attract mutual readers in with discussions of colossal acquisitions, or mouth-watering dividend pay-outs. However, the capital structuring of an organisation is, undeniably, a fundamental aspect which contributes towards a company’s – and ultimately its shareholders – success (Myers, 1984).

This blog will try to present the importance of capital structuring through presenting oil “galactico”, Petrobras.

Petrobras is a semi-public Brazilian multinational energy company which was once the guiding light and shining hope in Brazil’s developing economy, but in its current state, analysts suggest the company should be one of the most fearful for its future in this time of deflating global oil prices.

Now, in theory, there are potential advantages to a company being part-owned by a government: they benefit from government surpluses to run sound business projects; they enjoy financial autonomy; profits are utilised for further expansion activities; government facilitates development by taking up projects where private sectors hesitate to invest (Chang, 2007). Unfortunately for Petrobras, some of these “advantages” have been corrupted and ultimately left the company in a fragile state. The key underlying issue which can be linked to Petrobras’ fragility is the company’s unsustainable capital structuring.

It must be remembered that Petrobras has an abundance of investors (shareholders) on the New York Stock Exchange and Sao Paolo Stock Exchange who have a very legitimate stake in the company’s financial performance. But this stake is apparently being diminished by the overbearing Brazilian government and consequently destroying value creation throughout the organisation.

The government’s heavy influence in Petrobras’ operations has possibly led to less incentive for producing profits and less incentive to improve long-term value as government agencies are incentivised to spend entire budgets and grow larger, allowing them to acquire more power and bigger budgets for next year. Petrobras spent a relatively similar amount on capital expenditures ($135bn) between 2011 and 2014 as the public Supermajor companies. However, in the same time period, the company’s debt has grown from $70bn to $140bn whilst their EDITDA ratio has deterred from 31% to 22% (Forbes, 2015). It has been argued Petrobras is being used more as a political tool, rather than a value creating company (Livsey and Armstrong, 2015) and this has led to some directors – who are also government officials – driving overly-ambitious projects in Brazil’s coast which have required more and more debt financing.

Debt financing is widely accpeted as cheaper than using equity through its ability to lower the required rate of return, and simultaneously lowering the WACC of a company (Lee, 1996). Although, there can be a tipping point at which it endangers a company’s sustainable competitiveness and value creation (Myers, 1984), and with the anti-inflation of oil prices impacting the industry, Petrobras have been left exposed to dangerous repercussions. The company could not generate enough cash flow to cover its financing when the price of oil was at $90 per barrel, if this price continues to drop Petrobras will retrench further. Credit ratings firm, Moody’s, recently stripped Petrobras of its investment grade rating (Forbes, 2015), highlighting that shareholder value has been damaged over recent years, this aligns with diving share price at the company (Figure 1).

Figure 1: Petrobras share price: 2011-2014

 

Source: www.nasdaq.com (2015)

It is clear that a poor managerial approach to capital structuring has placed Petrobras in this dangerous position. This case provides a stance that shareholders are indeed an invaluable aspect of an organisation which can drive success. It could be argued that if shareholders (investment funds etc.) had a greater stake in Petrobras over the Brazilian government, their desire for value creation may have awoken the company earlier to these very serious capital structure issues.

The Brazilian government may have to face a harsh reality: it will have to either sell a portion of its assets to direct competitors or raise finance through equity, and therefore risk losing its controlling stake in the company.

Assessed Blog 1 - Shareholder wealth vs Stakeholders: Business’ Biggest Battle

Shareholder wealth vs Stakeholder legitimacy

The age old theory surrounding a corporation’s primary financial objective dictates that a company must only use its resources and engage in activities designed to increase its profits, so long as it engages in open and free competition without deception or fraud. This notion was initially proposed by Adam Smith in 1776, but has since been advocated and developed by numerous scholars - most noticeable of its enthusiasts being Milton Friedman (1970). This concept has been widely accepted amongst Anglo-American organisations, and various organisations operating in free-enterprise and private-property social systems.

However, as time has progressed, the pluralism of western societies has increased and technology has advanced substantially; consequently the power and legitimacy held by numerous stakeholder groups within the business environment has grown exponentially. Many academics have noted the amplified scrutiny society places on corporate social behaviour and the ease of exploiting any controversial business activity via limitless media outlets (Coleman et al., 2010; Freeman, 2004; Magness, 2008).

Tax avoidance

Corporation tax avoidance has become one of the more heavily scrutinised business practices within the media, especially amongst Anglo-American companies within western societies (e.g UK and USA). With the aim of maximising shareholder wealth, a multinational company may use the management of tax payments as one strategic manoeuvre of controlling and minimising the firm’s financial outgoings.

This could be achieved through the strategic structuring of an organisation. Apple Inc. is one of the (more than few) companies which have been heavily scrutinised for such organisational structuring. For example, an offshore subsidiary of the company (Apple Operations International) “which from 2009 to 2012 reported a net income of $30bn, but declined to declare any tax residence, filed no corporation income tax return and paid no corporate income taxes to any national government for five years” (Peston, 2013). Another Apple partner, conveniently based in low-tax Ireland, Apple Sales International, purchases Apple’s finished products from a manufacturer in China and then re-sells them “at a substantial markup” to other parts of Apple’s territory. This Irish-based subsidiary generated around $74bn in profits but may have paid little income taxes to any national government on the bulk of those funds.

According to Friedman’s (1970) proposal, Apple’s approach is perfectly fine, and perhaps a great strategic move. The company’s tactic has acted within the confines of the law – although one or two loopholes may have been discovered along the way – and has evidently provided the company with maximised profits which can ultimately be utilised to improve shareholder wealth through various methods (improved dividend payments, reinvestment into company expansion etc.). Apple have merely utilised ‘Taxation Treaties’ which have set up between countries and enabled corporations to only be taxed in one of those countries used during the strategic process. Apple have clearly been rather astute in their tax management and subsequently reduced their potential tax payments significantly, allowing for maximised net profits, which is a statistic many (if not all) of their investors will love.

However, on the other side of this discussion’s spectrum, Freeman’s Stakeholder Theory (2004) argues that a company’s responsibility must consider all of its key stakeholders (Figure 1). Although tax avoidance can be viewed to have great benefits for some of the stakeholders shown in Figure 1 (e.g. financers, employees, customers), this behaviour could arguably have some detrimental implications for other stakeholders.

Figure 1: Stakeholder Approach: Core Stakeholders of a Firm

Source: Freeman, Harrison & Wicks, 2007, cited in Beauchamp et al., 2009: 61

Firstly, it is clearly evident that governments are being controversially snubbed of corporate tax payments, which plays a significant role in government/federal income. For example, in the US, corporate tax generated 32.1% of all federal taxes in 1952. Today the proportion has fallen to around 9% (Kocieniewski, 2011; Peston, 2013). Part of that monumental decrease could be down to external factors influencing different tax category increases (imports, income and wealth, social contribtions etc.), however the 9% figure still reflects the US system is achieving poor figures from corporation tax (Kocieniewski, 2011).

These findings remain consistent with a broad trend of multinationals paying a much smaller proportion of public sector costs in all the world’s developed economies. Considering this is a time when government debt within many western countries is intensifying, it seems unfair that big multinational companies are not fairly contributing towards optimally repairing damaged economies.

Of course, it is not just Apple who have been scrutinised for their ability to find loopholes within tax payment regulations. Other high profile accusations of similar behaviour have been made about Google, Amazon and Starbucks, just to name a few. If this behaviour continues, and governments fail to implement efficient and agile regulations which can counteract unethical tax avoidance strategies from multinational corporations, it could erode the infrastructure of the global economy which once allowed these companies to thrive. The implications of this could ultimately be detrimental to all shareholders and stakeholders involved.