analyzing cash returned to stockholders
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Analyzing Cash Returned to Stockholders. 05/30/07 Ch. 22. Dividends and stock buybacks. The two major means of returning cash to shareholders is dividends and stock buybacks - PowerPoint PPT PresentationTRANSCRIPT
Analyzing Cash Returned to Stockholders
05/30/07
Ch. 22
Dividends and stock buybacks
The two major means of returning cash to shareholders is dividends and stock buybacks
The 1990s and 2000s have seen a dramatic increase in buybacks in the U.S. as a means for firms to return cash to stockholders.
Effects of buybacks: Reduces the book value of equity Reduces the number of shares outstanding Provides cash to stockholders selectively
Cash flow approach to analyzing dividend policy Measure cash available to be returned to
stockholders Assess project quality Evaluate dividend policy Examine the relationship between dividend
and debt policies
Cash available to be returned
The Free Cash Flow to Equity (FCFE) is a measure of how much cash is left in the business after non-equity claimholders (debt and preferred stock) have been paid, and after any reinvestment needed to sustain the firm’s assets and future growth. This is the cash available for dividend payouts.
Free cash flow to equity = Net Income + Depr&Amort – Chg in WC – Cap Exp + (New Debt Issue – Debt Repay)
– Pref. Dividends
Estimating FCFE when leverage is stableNet Income
- (1- ) (Cap Exp - Depr&Amort)
- (1- ) (Change in WC) – Preferred Dividends
= Free Cash flow to Equity
where
= Debt Ratio
How much of its FCFE is the firm paying out? Payout ratio can be measured as:
CF to stockholders to FCFE Ratio = (Dividends + Buybacks) / FCFE
If the ratio is: Less than 1 (firm paying less than it can afford), it may
be to maintain financial flexibility, because of volatile earnings, or for managerial objectives such as perks, empire building, etc.
NYSE average is around 50%.
The consequences of failing to pay FCFE
Chrysler: FCFE, Dividends and Cash Balance
($500)
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Year
Ca
sh
Flo
w
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
$9,000
Ca
sh
Ba
lan
ce
= Free CF to Equity = Cash to Stockholders Cumulated Cash
Dividends with negative FCFE (or payout ratios greater than 1) Some companies maintain payout ratios that
are greater than their available FCFE or sometimes pay dividends when the company generates negative FCFE.
How does a company with negative free cash flows to equity pay dividends (or buy back stock)?
Why might it do so?
Project (or investment) quality
The alternative to returning cash to stockholders is reinvestment. Therefore, the better a firm’s projects, the less a firm should return to
stockholders. Measuring Project Quality
Accounting return measure: Return on Capital vs. WACC
Stock price performance: Excess returns, which can be calculated as the actual return on the
stock minus the expected return based on CAPM In an efficient market, this can be considered to be an evaluation of
whether a firm earn a return on its investments that were greater than or less than those expected by the market.
Evaluating dividend policy
Based on FCFE and project quality, we can determine whether a firm’s current dividend policy is appropriate.
Four scenarios are possible.
Scenario one
A firm may have good projects and may be paying out more than its free cash flow to equity.
The firm is losing value in two ways. It is creating a cash shortfall that has to be met by
issuing more securities. Overpaying may create capital rationing constraints; as
a result, the firm may reject good projects it otherwise would have taken.
Possible cause for concern if dividends are cut: How can the firm reduce dividends without having investors think it is a negative signal?
Scenario two
A firm may have good projects and may be paying out less than its free cash flow to equity as a dividend.
This firm will accumulate cash, but stockholders are unlikely to insist that it be paid out because: It is likely that the excess cash will be used
productively in the long-term. Stockholders trust the actions of management
Scenarios three
A firm may have poor projects and may be paying out less than its free cash flow to equity as a dividend.
This firm will also accumulate cash, but find itself under pressure from stockholders to distribute the cash.
Scenario four
A firm may have poor projects and may be paying out more than its free cash flow to equity as a dividend.
This firm has an investment problem (bad projects) and a dividend problem (need to raise capital to pay dividends).
Although dividends should be cut to match the firm’s FCFE, the firm would be better off being more prudent about their project selection.
Improving project returns will increase FCFE, thus allowing for higher payouts. If FCFE is still insufficient to meet dividends, the firm should then cut dividends
Relationship between dividend and debt policies Dividend policy analysis is further complicated if a
firm’s debt policy is considered. Is the firm attempting to move to its optimal debt ratio?
Increasing dividends (or buybacks) can serve as a means for a firm to increase its leverage or debt ratio.
Therefore, if a firm is under-levered (debt ratio < optimal debt ratio), it may choose to pay out more than its FCFE as dividends to increase leverage.
Conversely, an over-levered firm may pay out less than its FCFE to decrease leverage.
A Practical Framework for Analyzing Dividend Policy
How much did the firm pay out? How much could it have afforded to pay out?What it could have paid out What it actually paid out
Dividends+ Equity Repurchase FCFE
Firm pays out too littleFCFE > Dividends
Firm pays out too muchFCFE < Dividends
Do you trust managers in the company withyour cash?Look at past project choice:Compare
ROC to WACC
What investment opportunities does the firm have?Look at past project choice:Compare
ROC to WACC
Firm has history of good project choice and good projects in the future
Firm has historyof poor project choice
Firm has good projects
Firm has poor projects
Give managers the flexibility to keep cash and set dividends
Force managers to justify holding cash or return cash to stockholders
Firm should cut dividends and reinvest more
Firm should deal with its investment problem first and then cut dividends
Chapter 22 sections NOT covered
All sections including and after “A Comparable-Firm Approach to Analyzing Dividend Policy”