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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 = r_d(1-T_c)D/V + r_eE/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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Shareholder Return: Dividends and Repurchases

This post relates to academic research that studies the multitude of factors affecting management decisions regarding how returns are distributed to stakeholders.

Investor returns not only constitute dividends, but also capital gain. The latter is used mainly as it presents financial benefits for the corporation, as it is considered a financial expense, reducing the firm’s income tax. On the other hand, shareholders face increased tax. This suggests management interests influences dividends and therefore highlights an agency problem between shareholders and executives (Decort and Procianoy 2012).

Nonetheless investor expectations are taken into consideration in dividend policy. For instance, stable dividends are preferred and expected by investors due to the minimal risk in returns (Lintner 1956). A deviation from shareholder expectations stimulates an immediate market reaction that can reduce the market capitalisation of the company. Despite this, the Miller and Modigliani theory asserts dividends and profit have no significant relationship in perfect markets; rather, the risk of its assets is key to determining the value of a firm. However, market imperfections such as agency conflicts, transaction costs and asymmetrical information are factors that influence dividend decisions as then it affects the value of the firm (Miller and Modigliani 1961). Baker and Powell (1999) argue dividend policy has an influence on firm value, and such dividend relevance is due to bird in the hand, tax preference, signalling and agency explanations.

Bird in the Hand Explanation - This argument states dividends act as a certain investor return relative to capital gains, hence provides a tangible incentive to ensure investors do not abandon the stock. Due to lower risk of dividends, companies should maximise dividend payout ratio and set high dividend yield to increase share price, since companies with a track record of dividend payments are traded at a premium (Fama and French 2001). However, Bhattacharya (1979) argues otherwise, stating that maximising the present dividend payout ratio will reduce the stock’s ex-dividend price. Therefore such a strategy will fail to maximise company value by lowering risk of future cash flows.

Signalling Explanation - Dividend policy communicates information to investors regarding the company’s earnings and future prospects. Dividend announcements reveal management’s perspective of the company’s future profitability (Miller and Rock 1985). Asymmetry of information implies internal management hold greater information than external investors, hence dividend changes reduce such asymmetry by allowing investors to analyse the stock price. Battacharya (1979) considers the shareholders’ horizon as a finite period, hence a high dividend payout signals it has invested in projects with high net present value therefore providing sufficient cash flow to honour the shareholder’s expectations. Dividends therefore provide information regarding both past and present earnings (Benartzi et al. 1997), suggesting market responses to changes in dividends are delayed responses to previous changes in earnings (Koch and Sun 2004).

Firms that use signalling tend to experience lower growth and higher variability in earnings but higher increases in asset turnover, are smaller and are less dependent on debt financing in the long term (McCann and Olson 1994), suggesting these are also internal factors influencing the allocation of dividends.  However such dividend changes are ambiguous until the market is able to recognise between firms in the growth stage and firms with minimal investment opportunities (Easterbrook 1994). Soter, Brigham and Evanson (1996) report that when FPL Group announced a 32% cutback in its quarterly dividend, the market reacted negatively through a 20% stock price decline. However, analysts realised such a dividend policy was strategic to enhance long-term growth opportunities and financial flexibility as opposed to signalling distress.

Li and Zhao (2008) also repudiate signalling theory and find ceteris paribus, information asymmetry causes firms to distribute smaller and less dividend payments and are less likely to increase such returns, casting doubt on the practicality of signalling theory.

Tax-Preference Explanation - Tax preference theory argues investors favour fund retention over dividend payout as otherwise only specific investors, that is, those subject to minimal tax rates, would be attracted to invest. The tax clientele effect applies to stocks with low payouts, as they should only attract higher taxed investors. Such investors favour capital gains, hence minimising dividend payout will maximise stock prices.

Agency Explanation - Jensen and Meckling (1976) advance the agency theory, which posits dividend policy acts as an incentive for management to reduce agency costs derived from the conflict of interests between internal management and shareholders. Agency costs increase if management exploit the perquisites out of retaining funds, and investing them in a sub-optimal manner. As maximising dividend payout reduces internal cash reserves controlled by management and increases external financing into the company’s capital structure, external capital suppliers therefore subject the company to increased scrutiny, diminishing the likelihood of suboptimal investments (Rozeff 1982). Thus dividend payments provide a mechanism to monitor management performance and align them to shareholder interests.

Premiums - Share repurchase is another form of investor return as the firm exchanges cash for shares owned by investors. Under the signalling theory, providing such a return occurs if the firm believes share prices are under-priced on a fundamental basis, or if they desire to increase their earnings per share (Stephens and Weisbach 1998), particularly if there were tax savings in adding debt to capital structure, increasing leverage (Young 1969). However, Wanscly, Lane and Sarkar (1989) finds three factors more directly affecting share repurchase decisions are to eradicate shareholders’ structure to minimise administrative burden of having minority shareholders, defend against takeovers, or if they have excess cash with limited investment opportunities. Excess cash results in the agency problem as management may invest in sub-optimal investments, hence the firm must pay out the excess cash through either stock repurchase or dividend payout. Due to the reputational penalties involved in volatile dividend payouts, management have greater incentive to retire stock instead. This also allows them to provide shares for internal programs such as exercising stock options or employee bonus and retirement programs.

Case Studies

Share Repurchase

Lynas Corporation, currently experiencing a deteriorating economic condition and financial distress due to the firm’s inability to cover operating and capital costs (Forbes 2014), have not issued any share buyback offers.  Tabtieng (2013) states terminating this mechanism of return provision is influenced by stock price changes. If the company’s stock price increased from its current level of 8.3 cents (ASX 2014), Lynas Corporation could resell to gain, unless they value ownership structure over financial statement content. This is because in terms of financial statements, surges in inappropriate retained earnings whilst outstanding and nonoutstanding shares are reduced means shareholder equity is on par with previous periods.  However, the company gains through an ability to pay out dividends or maintain a buffer against economic downturns. Under the signalling theory, providing such a return would signal that Lynas shares are underpriced on a fundamental basis, or they desire to increase their earnings per share (Stephens and Weisbach 1998).  As a result, we believe Lynas Corporation should consider the positive impacts of share repurchase as an investor return instrument.  

Likewise, Lynch (2014) focuses on BHP’s minimisation of gearing levels to 30% and their goal to maintain annual capital expenditure at $15 billion, which can both trigger share repurchase and investments.  BHP Billiton, one of the world’s largest producers of major commodities, is a company in a relatively ‘strong’ financial position, posting an underlying attributable net profit of US$7.8 billion for the half year ended 31 December 2013 (BHP 2014).  While share repurchase enables debt reduction, we believe that due to the internal competition for available capital and growing share price, BHP should favour long term investor returns from growth investment rather than short term cash dividends or buybacks.

During the December 2013 half year BHP issued a four tranche Global Bond, providing investors with fixed levels of returns from 2.050% to 5%, and a floating rate option, depending upon investor risk preference (BHP 2014).  Its Senior Floating Rate Notes due in 2016, provided investors with a return only 25 basis points above US Dollar LIBOR due to the high credit rating of the company and its senior debt as A1, an upper medium grade investment quality, highlighted in Moody’s BHP Biliton Limited Credit Rating (2014).  It could be inferred that BHP’s chosen capital structure, with debt to equity ratio currently 0.4, is successful in achieving minimum debt financing costs, while providing sufficient cash flow to meet its commitments. However, Heath Jansen, Citi analyst, posits that the main limitation BHP faces in increasing their payout ratio (including repurchases) was their net debt, which once cut to $20 billion, should increase dividends by 7%.

Stock repurchase has a stronger practical application in BHP. According to BHP Billiton (2011), their repurchase of 4.4% of its issued equity capital was priced at a 14% discount at $40.85 per share. This, like Lynas, can improve earnings and cash flow per share and return on equity given the lesser amount of issued capital, benefiting all shareholders regardless of their participation. For instance, the investors’ capital proceeds accumulate to $9.31, $9.03 of it being the difference between the tax value and the buyback price. The significant factor affecting the buyback was external, being the oversubscription by investors which introduced the need to scale back tenders. Shareholders who sold back their stocks at 14% discount had a priority allocation of shares repurchased before such a scale back was applied.

BHP’s recent announcement of a buyback despite failure to execute suggests it acts as a marketing mechanism, to facilitate a shareholder friendly image (Lücke and Pindur 2002). Chambers (2014) suggests the buyback deferral provides predictability in future cash returns. Capital losses have also been prevented by investor anticipation of BHP’s buyback, as seen by its uncorrelated trajectory with iron ore prices (Chunn 2014). Such a decision not to deliver however has stimulated downgrades by Credit Suisse, a response that we agree with, as in the long run BHP cannot trade above its core valuation. BHP therefore valued a short term shareholder friendly reputation over the negative implications of uncertainty surrounding its capital management.

Dividends

BHP Billiton supports optimal dividend policy in terms of their progressive payout model, where they increase or at least preserve their base dividend for each payment (BHP 2014). Despite their recent profit collapse of 30%, BHP still managed to increase its dividend by 2 cents, up from $US0.57 to $US0.59 (Mason 2014).  In fact, ceteris parabus, lower dependence on the mining sector due to declining iron ore prices translates to a free cash flow pre-dividend payout of $10 billion; a margin sufficient to rebase dividends upwards by 5%-10% in the next financial year (Ker 2014). However, Lynas Corporation has not provided such returns, in fact they have refrained from paying any dividends due to their decline in financial performance (ASX 2014). Lynas Corporation’s actions still support the significance of the optimal cumulative dividend model, as cutting back on dividends has produced a greater negative reaction relative to a predictable dividend payout ratio (Jose and Stevens 1989).

Moreover, Neems (2014) reports that BHPs demerger resulted in returns in the form of shares in the new company and involved a transferral of only minimal debt so as to not override equity holder returns. We disagree with their current dividend policies, instead recommending management should look to increasing the dividends at a faster rate. BHP’s dividend yield is a mere 3% at current market prices, which combined with relatively costly stocks that have underperformed recently, leaves investors expecting higher returns (Mason 2014).

Their decision to retain their progressive dividend payout model means the dividend decision remains a residual decision dependent on cash reserves. However, BHP’s estimation that the company loses $135 million with each incremental dollar fall in iron ore prices questions the remaining reserves (Bell 2014), placing emphasis on the formulating of a long-term market share strategy to appease investor return demands.  Colonial First State approximates that in 2014, there was a $300 billion fall in capital expenditure in the resources sector (Ker 2014), resulting in long term supply shortages. However, continuously investing in BHP’s asset base will increase long term supply. The fact that this contradicts shareholder demand for dividends and buybacks highlights the need for BHP to deliver returns in another form such as discounted shares or a renounceable rights offer.

Contrastingly, Lynas Corporation has opted for such returns, partly due to their lack of dividends from financial distress. Lynas Corporation: shareholder entitlement offer (2014) reports on an offer in which 150 million new shares to institutional investors raised $83 million and existing shareholders were given a renounceable offer of 5 new shares priced at 9 cents a share, 2.5 cents lower their previous market price for every 14 shares already held. The subsequent market selling resulted in speculative capital gains before the share price dropped down to 9 cents.

Further, levering the firm through a strict and conditional senior loan facility of $225 million provides investors security in the event of further debt raising, as 50% of debt finance will first be used for partial investor repayment until the principal falls to $125m. (Lynas Corporation 2014). My recommendation for Lynas Corporation management involves a stronger focus on restructuring loans to amend Lynas’ debt amortization schedule to align it with planned future profitability (Roddan 2014), whilst reaping in the additional funds raised from the discounted share placement. Therefore this will improve liquidity, debottleneck operations and effectively transition the company from a start up stage to a growth stage through funding further investments (Morningstar 2014).

Singaporean Dollar: Forecasts and Reasons

The perception of Singapore as a favorable investment haven due to its high ratings on economic growth, low government corruption and transparency contrasts to their weak underlying economic fundamentals. Its fragility is mainly derived from its dependence on the cost of capital remaining low or growing at a relatively slow and consistent rate. That is, if US rates increase earlier than expected the SGD dollar will slump. Why? The problem originates from the US Fed's quantitative easing approach undertaken from 2009-2013. Whilst the US' quantitative easing consequences were intended for domestic growth purposes, the stimulus created bubbles in foreign emerging economies. 

The SIBOR (Singapore Interbank Offered Rate) is linked to the US Federal Funds Rate in order to reduce volatility in the exchange rate. Therefore low Fed rates become a direct channel to form Singapore's credit bubbles. Since the SIBOR sets mortgage and loan prices, cheap credit meant household debt to GDP soared by 32% from 2005-2014. Singapore's property market prices also rose by over 50% from pre-GFC prices, now making it the third most expensive real estate market after Canada and Hong Kong. In fact, The Economist reports a 60% overvaluation of the Singaporean property market against the long term mean. If this asset bubble is popped, the banking sector will also suffer as half the banks' credit portfolios consist of general property loans, with a third being mortgages. Recently, the mean Singaporean mortgage rate has remained at approximately 1%. An increase of just one more percentage would result in interest costs more than covering the principal. Moreover, since the majority of these loans currently use floating interest rates, mortgage repayments will rise and reveal unsustainable debt once the Fed Rate increases to its historical average of between 3-6%. In fact, the prospect of a US interest rate hike for the first time in nine years was revealed today, mainly based on the fact that the number of job postings was the highest in fourteen years. As the Singaporean economy specialises in finance and property, effects are compounded, with the potential to mirror the post 2008 Irish economic crisis (where property values collapsed) and the 2008-2011 Icelandic crisis (where the banking system collapsed).

However, I do acknowledge that whilst the bubble is correlated with US monetary policy, the rate of return to average interest rates will be likely slow, allowing time for adjustments in Singapore. This centralises the risk on rates increasing before analyst expectations. Either or, conveying a bearish sentiment on the Singaporean dollar using long term call options is the best way to make returns from rising US rates and its consequences.