Lesson 8 Flashcards
what is dividend policy? what is the purpose of dividends?
a. the choices made by the company regarding the DISTRIBUTION OF PROFITS to shareholders and, COMPLEMENTARY, the REINVESTMENT of profits within the net capital of the company. The company has the ability to EXCHANGE immediate CASHFLOWS with future GROWTH
b. maximizing the value of equity, as always
the 2 indicators defining dividend policy
- payout ratio: Div_1 / NP_0
- plowback ratio: 1 - payout ratio
valuing equity through dividends
assuming the market is in EQUILIBRIUM, the return offered by the stock to the shareholder must be equal to the opportunity cost of the stock itself
the current price of the stock is represented by the current value of the cashflows that the stock will bring to its shareholders (dividend, price, and risk) > since any further investor will need to define the price at the time he buys the share, this approach can be used whatever the investment horizon is
!!! future dividends are “implicit” and contained in the share price at t+1, and so forth !!!
why isn’t the value of a stock represented by the discounted value of PROFITS?
because profits do not record the value actually distributed to shareholders but can be reinvested generating a growth in the profits themselves (and so of dividends)
we care about the discounted value of DIVIDENDS
why does the value of distributed dividends tend to increase over time?
because if dividends distributed <= NP, the company increases its NW every years, financing a growth of the activities
for the value of dividends to increase, is it necessary for the company to obtain a positive NPV on the additional NW?
NO NO NO NO
it is necessary for the company to extract a POSITIVE ROE from its additional capital, !!!!! even with REDUCED or NEGATIVE NPV !!!!!
analyst’s advantage over simple time series for the estimation of g
g tends to decrease over time and analysts adjust for this
g tends to be greater at the industry level than at the company level
g tends to be greater for larger companies than for small companies
what is a common misconception about ROE contained in the GROWTH HYPOTHESIS?
ROE in the growth hypothesis is a PROSPECTIVE ROE and should NOT be CONFUSED with HISTORICAL ROE (company may have obtained disappointing results in past year but have good future investment opportunities and vice-versa)
ROE HISTORICAL = ROE PROSPECTIVE ONLY IF IT IS EXPLICITLY ASSUMED THAT THE RETURN CONDITIONS OF FUTURE INVESTMENTS REMAIN THE SAME
why the ROE and PLOWBACK values chosen have to be “sustainable” over time?
because the DDM assumes that this process continues over an infinite time horizon
noteworthy case 1
what if plowback = 1
(remember we are assuming an infinite time horizon)
then the payout = 0 , and the value P_0 is zero since the shareholders will not receive any cash flow in the future
noteworthy case 2
what if the value of the g > k_e?
the value of the company is infinite
noteworthy case 3
payout = 1
P_0 = NP_0 / K_e
the effect of expected ROE on value: DDM
ROE > k_e creates value
in this case we should** max plowback (99%)** and min payout (1%)
ROE = k_e equilibrium condition
dividend policy is INDIFFERENT (theory of “neutrality” of dividend policy in perfectly efficient markets)
ROE < k_e destroys value
!!!! we should max payout (100%)
!!!!!!!!!!
the value of a company that grows in EQUILIBRIUM (IRR=k_e and NPV = 0) is EQUAL to that of a company that DISTRIBUTES ALL THE PROFITS and does NOT GROW (steady state)
!!!!!!!!!!
in operational REALITY, relationship between ROE and k_e is NOT CONSTANT, and generally DECREASING as the INVESTMENT INCREASES
2-stage DDM
value over the planning horizon + discounted terminal value
!!!! while k_e can be the same for the two stages, the value of “g” LONG TERM has to be defined. Sometimes it can be assimilated to that of the ECONOMY in the LONG RUN
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
a possible solution to determine the correct LONG TERM GROWTH is to assume that the ROE of FUTURE INVESTMENTS is EQUAL to the COST OF CAPITAL
g* = k_e * plowback
PVGO, theory and formula
the net present value** (NPV)** of future investments of a company that, by reinvesting a portion of the profit and growing its capital, consequently sees its profit and future dividends grow at a rate “g”
the value of growth opportunities can be calculated as the difference between the value of a company that will grow by creating NPV and that of a company that will invest in the same way but with an NPV = 0
!!! in most cases, sustained growth is associated with a sacrifice in terms of profitability margins
