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.