Cash dividends
Stock price will drop by the dividend amount, but the wealth of shareholders will not changes if there is no tax.
Stock dividends and stock split
Generally not taxable to shareholders.
The proportionate ownership and wealth of shareholders will not change.
Effects of dividends on financial ratio
Cash dividends Reduces both the asset and shareowners' equity. Liquidity ratio will decrease (current ratio, etc).
Financial leverage ratio will increase (D/E, D/A).
Stock dividends and stock split
No effect on total asset and total shareowners' equity, but number of shares will increase.
Both share price and EPS will decline.
Dividend Theories
Theories
Dividend policy does not matter(MM)
Dividend policy does matter
Bird-in-hand argument
Tax argument
Other theoretical issues
Information signaling
Agency costs
Information Signaling
Dividend increases or decreases may affect share price because they may convey new information about the company.
Dividend declaration resolves information asymmetry Initiations or increases convey positive information. Omissions or reductions convey negative information.
Companies that consistently increase their dividends seem to share certain characteristics: Dominant or niche positions in their industry Global operations
Relatively high returns on assets
Relatively low debt ratios
Agency Costs
Between shareholders and managers
Dividends payout reduces free cash flow for managers to overinvest and run out of control.
Between shareholders and bondholders
All else equal, both dividends and share repurchases increase the risk that the company will default on its debt
Dividends transfer wealth from bondholders to shareholders.
Tax Considerations
Double taxation system
Corporate pretax earnings are taxed at the corporate level and then taxed again at the shareholder level if they are distributed to taxable shareholders as dividends.
Dividend imputation tax system
Effectively ensures that corporate profits distributed as dividends are taxed just once,at the shareholder's tax rate.
Split-rate tax system
Corporate earnings that are distributed as dividends are taxed at a lower rate at the corporate level than earnings that are retained.
Dividends Payout Policies
Stable Dividend Policy
Most common used policy.
A process of gradual adjustment towards a target payout ratio based on long-term sustainable earnings.
Expected dividend = Previous dividend + (Expected earnings x Target payout ratio - Previous dividend) x Adjustment factor
Adjustment factor = 1/N (N is the number of years over which the adjustment in dividends should take place)
Constant Dividend Payout Ratio Policy
A dividend payout ratio decided on by the company is applied to current earnings to calculate the dividend.
Payout ratio = Dividends paid / Net income
Infrequently used, fluctuate with short-term earnings.
Share Repurchase and its Effects
Concept of share repurchase
Share repurchase: a transaction in which a company buys back its own shares.
Can be viewed as an alternative to cash dividends.
Treasury shares/stocks: shares that have been issued and subsequently repurchased.
Not considered for dividends, voting, or computing EPS.
Share repurchase methods
Buy in the open market
Flexibility in timing and amount.
Tender offer邀约收购，广而告之 Fixed price tender offer: buy a fixed number of shares at a fixed price, typically at a premium to market. Dutch auction: use auction to determine the lowest price.
Direct negotiation单独协商
Typically at a premium to market.
Effect on EPS
Repurchased with excess cash (financed internally) Asset (cash) and equity will decline
Financial leverage ratio (D/A, D/E) will increase. EPS will increase (only if the fund used to repurchase do not earn their cost of capital).
Repurchased with debt (financed externally) Debt increase and equity decline
Financial leverage ratio (D/A), will increase (even more than repurchase by excess cash).
If earning yield(E/P) > after-tax cost of debt, EPS will increase
If earning yield(E/P) < after-tax cost of debt, EPS will decrease
Effect on Book Value Per Share(BVPS)
BVPS = Book value of equity / shares outstanding
Share repurchase will result book value per share (BVPS): Decrease, if the repurchase price > the original BVPS. Remain the same, if the repurchase price = the original BVPS. Increase, if the repurchase price < the original BVPS.
Analysis of Dividend and Share Repurchase
Dividends vs. Share Repurchase on shareholders wealth
Assuming the tax treatment of these two methods is the same, a share repurchase has the same impact on shareholder wealth as a cash dividend payment of an equal amount.
If a company repurchases shares from an individual shareholder at a negotiated price representing a premium over the market price, the remaining shareholders' wealth is reduced
Dividend vs. Share Repurchase
Share repurchase wins in aspects of
Potential tax advantages
Share price support/signaling that the company considers its shares a good investment
Added managerial flexibility Offsetting dilution from employee stock options Increasing financial leverage Increasing EPS
A company can use both special cash dividends and share repurchases as a supplement to regular cash dividends.
These means of distributing cash are often used in years when there are large and extraordinary increases in cash flow that are not expected to continue in future years.
A share repurchase is effectively an alternative to paying a special cash dividend
Analysis of Dividend Safety
Dividend payout ratio = dividends / net income
Dividend coverage ratio = net income / dividends
FCFE coverage ratio = FCFE / (dividends + share repurchases)
Warning signals for dividend cut:
Negative external stock market indicators
Extremely high dividend yields
ESG Considerations in Investment Analysis
Global Variations in Ownership Structures
Ownership Structures
Dispersed vs. Concentrated Ownership
Dispersed ownership: none of shareholders have the ability to individually exercise control over the corporation.
Concentrated ownership: an individual shareholder or a group (called controlling shareholders) with the ability to exercise control over the corporation.
"Hybrid" corporate ownership
On a global basis, concentrated ownership structures are considerably more common than dispersed ownership structures.
Other Ownership Structures
Horizontal ownership: companies with mutual business interests (e.g., key customers or suppliers) that have cross-holding share arrangements with each other.
Vertical ownership(pyramid ownership): a company or group that has a controlling interest in two or more holding companies, which in turn have controlling interests in various operating companies.
Voting power
Dual-class shares: grant one share class superior or even sole voting rights, whereas the other share class has inferior or no voting rights.
Benefit: lower risks associated with principal-agent problems(concentrated ownership and management responsibility).
Drawbacks: poor transparency, lack of management accountability, modest consideration for minority shareholder rights, and difficulty in attracting quality talent for management positions.
State-owned enterprises (SOEs)
Institutional investors
Group companies
Private equity firms
Foreign investors
Managers and board directors (insiders)
Effects of Ownership Structure on Corporate Governance
Independent board directors(or independent board members 独立董事会)
No material relationship with the company with regard to employment, ownership, or remuneration.
United States requires audit, nomination, and compensation committees be composed entirely of independent directors.
Board Structures
Special voting arrangements: improve the position of minority shareholders in board nomination and election processes.
Corporate governance codes, laws, and listing requirements
Stewardship codes投资人尽责条款: voluntary codes that encourage investors to exercise their legal rights and increase their level of engagement in corporate governance.
Corporate Governance Evaluation
Board Policies and Practices
Board of directors structure
CEO duality两职合一: CEO also serves as chairperson of the board.
Raise concerns that the monitoring and oversight role of the board may be compromised relative to independent chairperson and CEO roles.
Board independence
A lack of independent directors on a board may increase investors' perception of the corporation's risk.
Board committees
Generally include audit, governance, remuneration (or compensation),nomination, and risk and compliance committees.
Assess whether there are sufficiently independent committees that focus on key governance concerns, such as audit, compensation, and the selection of directors.
Board skills and experience → board tenure
A board director's tenure is considered long if it exceeds 10years.
Board composition: reflects the number and diversity of directors.
Other considerations
Executive Remuneration
Involves such issues as transparency of compensation,performance criteria for incentive plans (both short term and long term), the linkage of remuneration with the company strategy, and the pay differential between the CEO and the average worker
"Say-on-pay" provision
Claw-back policy
"Excessive" remuneration → use KPI to analysis.
Shareholder Voting Rights
Straight voting share structure: one vote for each share owned.
Dual-class share structures: company founders and/or management typically have shares with more voting power than the class of shares available to the general public.
ESG-related Risks and Opportunities
Materiality and Investment Horizon
Materiality重要性 typically refers to ESG-related issues that are expected to affect a company's operations, its financial performance, and the valuation of its securities.
Positive ESG information ≠ material ESG information
Negative ESG information ≠ immaterial ESG information
Investment horizon
Short-term investment horizon considers short-term ESG issues, and vice versa.
Equity vs. Fixed-Income Security Analysis
ESG integration: the implementation of qualitative and quantitative ESG factors in traditional security and industry analysis.
Green Bonds
The bonds in which the proceeds are designated by issuers to fund a specific project or portfolio of projects that have environmental or climate benefits.
Green bonds are typically the same credit ratings and valuation to an issuer's conventional bonds, with the exception that the bond proceeds are earmarked for green projects.
Some green bonds may command a premium, or tighter credit spread, versus comparable conventional bonds because of market demand.
Greenwashing risk: the risk that the bond's proceeds are not actually used for a beneficial environmental or climate-related project.
Liquidity risk: when the investors are often purchased by buy-and-hold purpose.
Cost of Capital: Advanced Topics
Cost of Capital
Cost of capital factors
Top-down external factors
Capital availability
Market conditions
Legal and regulatory considerations, country risk
Tax jurisdiction
Bottom-up company specific factors
Revenue, earnings, and cash flow volatility
Asset nature and liquidity
Financial strength
Securities features
Cost of Debt
Cost of debt estimation
Traded debt: YTM
Non-traded debt
With credit rating: similar bond yield or similar maturities
Without credit rating: synthetic credit ratings
Bank Loans
The interest rate on recently new bank loan could be a good estimate, if market conditions and the company's risk profile has not materially changed.
Generally, amortizing loans typically have a lower cost of debt than non-amortizing loans.
Leases
Rate implicit in the lease (RIIL):
Incremental borrowing rate (IBR):
The rate of a collateralized loan over the same term
If IBR is unknown, the non-traded debt estimation method might be used.
Country risk rating(CRR)
Economic conditions
Political risk
Exchange rate risk
Securities market development and regulation
Equity risk premium
Estimating the ERP
Historical approach
Forward-looking approach
Survey-based estimates
Dividend discount models
Macroeconomic modeling
Historical Approach
Key assumption
Returns are stationary, and markets are relatively efficient, so over the long term, average returns should be an unbiased estimate of expected returns.
Key decisions
Selection of the equity index
Typically: broad-based, market-value-weighted indexes
Selection of the time period
Selection of the mean type
Selection of the risk-free rate proxy
Limitations of the historical approach
ERPs can vary over time.
Survivorship bias tends to inflate高估 historical estimates of the ERP
Forward-Looking Approach
The ERP depends strictly on future expectations, given that an investor's returns depend only on the investment's expected future cash flows.
Survey-based estimates
Dividend discount models
Macroeconomic modeling
Survey-based estimates
Assess expectations by asking people what they expect
Estimates tend to be sensitive to recent market returns
Dividend discount models (DDM)
Gordon growth model
ERP=E\left(\frac{D_1}{V_0}\right)+E\left(g\right)-r_f
Assumption: constant P/E.Earnings, dividends, and prices will grow at the same rate.
ERP estimates rely on forecasted economic variables.
Grinold-Kroner model
ERP=\left[DY+\Delta\left(\frac{P}{E}\right)+i+g-\Delta S\right]-r_f
Expected inflation
Expected inflation can be estimated as the yield on a US Treasury bond and a similar maturity Treasury Inflation-Protected Security (TIPS):
YTM_{\text{Treasury bond}}-YTM_{\text{TIPS}}
More reliable when public equities represent a relatively large share of the economy, as in many developed markets.
Limitations of the forward-lookjng approach
Surveys
Sampling and response biases
Behavioral biases(eg. recency bias,confirmation bias)
DDM
Assumptions of constant P/E is unreasonable.
Macroeconomic models
Modeling errors
Behavioral biases in forecasting
Cost of Equity
Cost of Equity for Public Companies
Models
DDMs
Bond yield plus risk premium approach(BYPRP)
Risk-based models
Capital assets pricing model (CAPM)
Fama-French models
DDMs
Requirements:
Publicly traded shares, stable and predictable dividend.
Gordon growth model:
\mathrm{r}_{\mathrm{e}}=\frac{\mathrm{D}_1}{\mathrm{p}_0}+\mathrm{g}
BYPRP is another means of estimating the required return on equity for a company that has public debt.
r_e=r_d+RP
r_d: proxied by YTM on the company's long-term debt RP: can be estimated using historical mean difference in returns between an equity market index and a corporate bond index
Advantages
Estimating cost of debt provides a starting point estimate of the return demanded by debt investors.
Disadvantages
Determination of RP is relatively arbitrary.
Requires company to have traded debt.
If a company has multiple traded debts with different features, there is no prescription of which to select.
Risk-based models
Capital assets pricing model (CAPM)
r_e=r_f+\widehat{\beta} \mathrm{ERP}
\widehat{\beta}: Regressing the company's returns on the market index returns with their actual historic data
Fama-French Models
r_e=r_f+\beta_1\mathrm{ERP}+\beta_2\mathrm{SMB}+\beta_3\mathrm{HML}+\beta_4\mathrm{RMW}+\beta_5\mathrm{CMA}
SMB: small minus big, size premium
HML: high(book-to-market) minus low, value premium
RMW: robust minus weak, profitability premium
CMA: conservative minus aggressive, investment premium
Cost of Equity for Private Companies
Expanded CAPM
Adds a premium for small company size and other company-specific risks.
r_e=r_f+\beta_{\text {peer }}( ERP )+ SP + SCRP
\beta_{\text {peer }}: an industry beta, from a peer group of publicly traded companies in the same industry
SP: size premium
SCRP: specific-company risk premium
Build-up approach
Implied beta is 1.0
r_e=r_f+ ERP +IP+ SP + SCRP
r_f+ ERP: average risk large-cap public equity
IP: industry risk premium
SP: size premium
SCRP: specific-company risk premium
Country spread models
Country risk premium (CRP) is required by investors for the added risk of investing in emerging markets (local country).
\begin{align}
&ERP_{\text{emerging market}}=ERP_{\text{developed market}}+\lambda\times CRP
\\
&CRP=\text{Sovereign yield spread}\times\frac{\sigma_{Equity}}{\sigma_{Bond}}
\end{align}
CRP: country risk premium
\lambda: the level of exposure of the company to the local country
\text{Sovereign yield spread}: The yield on emerging market bonds minus the yield on developed market government bonds.
\sigma_{Equity}: volatility of the local country's equity market
\sigma_{Bond}: volatility of the local country's bond market
Global CAPM(GCAPM)
Single factor: a global market index
Assuming no significant risk differences across countries International CAPM(ICAPM)
International CAPM(ICAPM)
E\left(r_e\right)=r_f+\beta_G\left(E\left(r_{g m}\right)-r_f\right)+\beta_C\left(E\left(r_c\right)-r_f\right)
r_{g m}: global index
r_{c}: foreign currency index
Capital Restructuring
Corporate Actions and Motivations
Types of corporate structural changes
Investment
Increase the size or scope of a company, thereby increasing the revenue and perhaps revenue growth.
Divestment
Reduce the size or scope of a company, through disposing of slower-growing, lower-profitability, or higher-risk operations to improve the overall financial performance.
Restructuring
Improve the cost and financing structure to increase growth,improve profitability, or reduce risks without altering the size or scope of a company.
Divestment action motivations
Focus operations and business lines
Valuation(Conglomerate discount多元化折价)
Liquidity needs
Regulatory requirements
Restructuring action motivations
Improve returns on capital(Opportunistic improvement主动, Forced improvement被迫)
Financial challenges, including bankruptcy and liquidation
Top-down
High asset prices
Greater CEO confidence
Lower cost of financing(Lower interest rates, Higher equity prices)
Overvalued stock prices
Industry shocks
Regulatory changes, technological changes, or changes in the growth rate of the industry
Types of corporate restructuring
Types of investment actions
Equity investment
Joint venture
Acquisition
Types of divestment actions
Sales/Divestiture
The seller sells a company, segment of a company, or group of assets to an acquirer.
Capital to be reallocated to a better use
The seller and acquirer both focus on their strengths.
Spin off分拆
A company separates a distinct part of its business into a new, independent company.
Remove incompatibilities, and to increase management and employee focus by
Separating distinct businesses
Awarding employees with stock-based compensation
Types of restructuring actions
Forced improvement
Cost restructuring成本重组: Reduce costs by improving operational efficiency and profitability.
Outsourcing外包 and offshoring离岸外包
Balance sheet restructuring: Shift the asset composition,change the capital structure, or both.
Sale leaseback售后回租
Dividend recapitalization借债回购股票
Reorganization重整: a court-supervised restructuring process
Opportunistic improvement
Alter the business model Franchising特许经营: An owner can divest its asset and license the intellectual property to a third-party operator
Cost restructuring
Balance sheet restructuring
Sale leaseback
Motivations
Unlock the value in the real estate assets which are a non-core business for a company with attractive valuations.
Improve a company's balance sheet by retiring debt and improving its credit rating.
Valuation
Cap rate: net operating income divided by property's value
Cap rate may be influenced by location and physical condition of the property.
Special case: leveraged buyout
An acquirer uses a significant amount of debt to finance the acquisition of a target and then pursues restructuring actions,with the goal of exiting the target with a sale or public listing.
A series of actions that include investment, divestment, and restructuring.
Evaluating Corporate Restructurings
Initial Evaluation
What and Why
Is it material: It is material if total transaction value of an acquisition exceeds 10% of the acquirer's enterprise value prior to the transaction.
When: There is a substantial time delay.
Preliminary Valuation
Definition: use relative valuation methods to judge whether management uses stakeholder resources optimally to meet investors' required rate of return on capital.
Comparable company analysis
Use the valuation multiples of similar listed companies to value a target company.
Enterprise multiples(e.g. EV/EBITDA or EV/sales) are less sensitive to differences in capital structure.
Earning multiplies: Price/Earnings,Price/sales
Comparable transaction analysis
Uses valuation multiples from historical acquisitions of similar companies to evaluate a target's value.
Valuation multiples include takeover premiums.
Premium paid analysis
Takeover premium收购溢价: The amount by which the per-share takeover price exceeds the unaffected price expressed as a percentage of the unaffected price.
PRM=\frac{DP-SP}{SP}
PRM: Takeover premium (as a percentage)
DP: Deal price per share
SP: Unaffected stock price per share
Modelling and Valuation
Issuer's motivations analysis
Pro forma WACC modeling
Capital structure
Issue new debt or equity
Repurchase stock or repay debt
Cost of capital: When issuing debt during restructuring, firms will try to keep its bond above investment grade.
