Thursday, 12 March 2015

Company Returns: Factors Determining Amount

This post relates to academic research regarding investor returns in the form of dividends, capital gain and share repurchase premiums. 

Dividends - In light of equity investors, Baker, Farrelly and Edelman (1985) propose that the optimal dividend policy exists, refuting Miller and Modigliani’s (1961) argument that dividend policies equally affect the company’s stock price and cost of capital. This is because Miller and Modigliani’s theory holds numerous restrictive assumptions, such as perfect capital markets, which fail to apply in reality. The optimal dividend payout is a balance between present dividends and long term growth that maximises share price.
Lintner (1956) theorises that despite management’s valorisation of a long-term target payout ratio, a steady increase in dividends is optimal. Decisions involving changes to dividend rates likely to have short-term reversal are overlooked in favour for partial adjustments towards the target ratio to smooth dividends. Such predictability ensures no short-term detrimental effects on stock price as it aligns with investor expectations. This behavioural model thus implies dividend change is a function of targeted dividend payout minus the previous period’s payout times by an adjustment factor, where the target is a proportion of the present period’s earnings. Therefore firms determine divident amount through a partial adjustment model, favoured by the market as it stabilises and grows dividends per share.
The amount of returns is further determined through the interrelationships between investment, financing and dividend decisions (Baker and Powell 1999). An insinuation of Miller and Modigliani (1961) is that dividend payouts remain a residual decision, hence the amount used financing investments from retained earnings determines dividend payments. This means if future investment opportunities are abundant, then dividends will be minimal if paid at all.  
Dividends are ultimately affected by earnings and cash flow per share, the latter calculated by dividing net income with a weighted average of outstanding common shares and the sum of net income, net working capital, depreciation divided by the same denominator respectively. Consler, Lepak and Havranek (2011) found cash flow per share has been found as a better determinant than earnings per share, as it is less sensitive to accounting manipulation, unlike earnings. Nonetheless Liu, Nissim and Thomas (2007) assert earnings forecasts better explain equity valuation than operating cash flows. This is explained by the constant dividend growth formula used to value stocks, as it implies investors maintain their investments if firms are able to demonstrate evidence of a record of steady dividend payments, and cash dividend payments terminate from significantly negative earnings (Fama and French 2001).  Ultimately cash flow facilitate earnings, explaining the correlation of earnings with cash dividends (Bali, Ozgur and Tehranian 2008). Likewise, the moving average of revenue is correlated with the present value of future dividends (Campbell and Shiller 1988).

High payout protects against crises as investors continue supplying funds despite a fall in the share price. Conversely, it can limit the firm’s capacity for growth as it has fewer resources for investment. Such an impact is maximised if they experience difficulties in debt financing. Hence the amount of dividends takes into account an ideal balance between meeting short term shareholder expectations and retaining sufficient funds for long term investment opportunities. The majority of managers in Decourt and Procianoy’s study (2012) emphasised on net profit as the most significant factor in dividend decisions, indicating variations in dividends imply their future expectations over profitability as a drop in dividend growth suggests lower expected earnings. External factors also affect dividend decisions, such as interest rate and exchange rate variations. The decrease in interest rates causes a decrease in debt, and 14% of executives agree this stimulates increases in dividend distribution. Economic crises likewise affect the dividend distribution, suggesting that firms are concerned with the widespread implications of a fall in dividends. Executive renumeration also influences the timing of dividend distribution, as firms that reward executives on the basis of profit distribute annual dividends whilst this observation tends to fall in firms that reward on other conditions.

Moreover, Griffin (2010) argues there exists an inverse relationship between dividend amount and a company’s stock liquidity, suggesting companies decide on higher dividend payments to compensate for a lack of liquidity. For illiquid stocks, investors increase waiting times for buyers and this pressures them to accept lower prices, allowing dividends to act as an income source. Meanwhile, liquid stocks are able to form artificial dividends for the investor, as they are able to sell stocks in a speedier time frame with minimal transaction costs. Liquidity also extends the possible positive net present value investments available as it minimises cost of capital (Becker-Blease and Paul 2006), confirming the inverse relationship since increased investing due to high liquidity reduces dividend amounts. Investors have a dividend preference based on stock liquidity due to trading friction inherent in financial markets (Banerjee et al. 2007), contrasting Miller and Modigliani’s (1961) assumptions of frictionless markets in Dividend Irrelevance Theory which posits investors are indifferent to dividends versus capital gain. They argue in frictionless markets, dividends reduce the end value of existing shares as the dividend stream is deterred to attract external capital from which future dividend payments are derived.

Local market liquidity additionally influences amount of returns since investors demand higher expected returns on assets sensitive to liquidity, particularly in emerging markets (Bakaert et al. 2007). Liquidity declines before expected announcements and after unexpected announcements due to the political and economic volatility of emerging markets (Graham et al. 2006). Hence in such cases dividend amount increases.

Despite dissimilar macro and micro influences, firm fundamentals and government involvement, the inverse relationship between dividend amount and liquidity extends to a global level. In Canada, over 70% of companies are owned by a small group of concentrated holders in a family operated pyramid structure, whilst over 70% of US companies are widely held, translating to more liquidity and hence greater dividends paid out in Canada (Baker et al. 2007). Griffin (2010) further found such a relationship occurs greatest in smaller firms, implying the size of the firm affects how well the firm is able to realise and react to the investors’ liquidity needs. Moreover, the dividend payment is also based on the country’s relations with the US stock market, where stock markets closely connected to the US exhibit a stronger negative relationship between stock liquidity and dividends as investors are willing to replace their home country’s stocks for US stocks if desired liquidity is not provided.

Share repurchase premiums - Contrastingly, Lucke and Pindur (2002) report shareholder returns in share buy-backs depend on the techniques employed in share repurchase. Such techniques include open-market (stock being bought back at current prices), fixed-price self-tender (offer lasting a specific period of time to purchase pre-determined amount of shares at premium) and Dutch-auction offers (firm specifies price ranges of tenders for greater success). If the intention was to usurp greater control and ownership, firms would offer a control premium, that is, a return to investors higher than the share’s fair value (Stulz 1988). This is due to the created wealth from value creation and value information, so the new value is P1 = (P0*N0+dW)/N0 where P1 is the new share price, P0 is the original market value, N0 is the number of shares, W is wealth.

The premium is determined by wealth creation plus the original share price added with the firm’s intrinsic value given the fixed price tender. It is also influenced by the full information premium, which is paid in addition to the intrinsic value of the firm resulting in a transfer of wealth towards tendering shareholders to compensate for the opportunity cost of capital gain (McNally 1998). As a result stock prices rise due to an imbalance between higher shareholder demand than supply, stimulating capital gain for shareholders whom lack interest in selling (Bagwell and Shoven 1989). Lücke and Pindur (2002) assert the premium combined with the expected new share price in fact results in a share price higher than both. However when the repurchase offer expires such capital gain decreases for the remaining investors. Thus if all shareholders tender, then wealth creation is equally shared, eliminating shareholder wealth transfer. Financial derivatives intensify such returns. Put options, for instance, allows speculation with greater leverage on the post-tender price. Rather than investing in a company’s equity, investors have the option to invest in a firm’s debt.  

Bonds - When investors purchase company debt instruments, the amount of returns provided is dependent upon on the characteristics of debt.  For corporate bonds, the most common form of corporate debt, the return level is determined by the market once these characteristics have been decided by the firm, and is equal to the yield to maturity of the bond.  The yield is initially set at the market price for the instrument’s risk level by adding a default premium to the risk-free rate of return (Babbel, Merrill and Panning 1997), resulting in the bond yield spread (Moeller and Molina 2003).  The default premium (which determines the credit spread) is based largely on the credit rating assigned to the debt instruments by a credit agency (Purda 2011).  

The factors that the company can influence in determining the amount of returns is limited primarily to its capital structure, financial policy and liquidity. Internationally, companies are inclined to issue debt as the value of interest tax shields increases the value of the firm, due to the Cost of Debt Capital = Coupon Rate on Bonds (1 - tax rate), making the after-tax WACC = rd(1-Tc)D/V + reE/V. However, in Australia with the imputation tax system the tax advantages of debt is decreased (Pattenden 2006), adding to the costs of financial distress in reducing the benefits of debt financing.  Rajan and Zingales (1995) found that debt ratios are dependent on four main factors: size, tangible assets, profitability and market to book, hence each company has a different ideal capital structure to maximise value.

In analysing specific debt issues, credit rating agencies first assess company credit rating and then further interpret the terms and conditions of the debt security, the relative seniority of the issue with regard to past debt issues and priority of repayment in the event of default, and the existence of external support or credit enhancements (Standard & Poor’s 2014).  Hence the company can influence the rate of return by deciding on the characteristics of its debt instruments which will influence their credit ratings, including the time to maturity (Purda 2011).

Following the issue of debt, bond market prices and yields will continually fluctuate, influencing the return investors receive should they decide to not hold the asset to maturity however, this is not within the control of the company (Aonuma and Tanabe 2011).  Prices are influenced as investors continually assess the debt instruments’ variable credit quality and investment merit, analysing shifts in the economic environment as well as entity, industry and debt-specific changes (Standard and Poor’s 2014).  Thus the relationship between inflation and interest rates upon bond yield and spot price is particularly important in determining the level of returns investors receive (Aonuma and Tanabe 2001).  

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