Analyzing Cash Returned to Stockholders 03/09/06

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 stable Net 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

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 little FCFE > Dividends Firm pays out too much FCFE < Dividends Do you trust managers in the company with your 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 history of 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