Do Dividends Matter?

Introduction

Does a company’s decision regarding its dividend distributions have an impact on the value of its equity? In short, do dividends
matter?

Dividends are irrelevant

In terms of classic finance theory, a rational investor should be indifferent between receiving a cash dividend from a share, or having the company retain the cash and re-invest it at the weighted average cost of capital. In this way, a stock trading at 10/share cum dividend (meaning the dividend belongs to the buyer of the share and not the seller) would trade at R9/share ex dividend (meaning the dividend belongs to the seller of the share and not the buyer), once the R1/share dividend has been paid, and the investor would be equally happy holding the R10 share without the prospect of a dividend. This school of thought, known as the dividend irrelevance proposition, has strong theoretical backing in a world where taxes are ignored, securities are fairly priced, and the cost of issuing new stock is negligible. An investor is indifferent to receiving returns in the form of dividends, stock appreciation or a combination.

Dividends do matter

However, in practice, the relationship is not always so simple. Several asset managers have stated their preference for dividend paying shares, as it is often indicative of a company which is stable and has matured to the point where sufficient free cash flow is being generated to justify a cash distribution. Certain types of investors, such as pension funds, have a need for regular  distributions (to cover either administration costs or the monthly income needs of its clients, especially the elderly) and have a
preference for dividend paying stocks. The market often takes a dim view of companies which are sitting on large cash reserves, especially where management has neither a credible plan for the investment of the funds nor the intention to return the funds to shareholders. It is not uncommon for management teams in this position to squander excess cash resources on overpriced acquisitions, or ventures not related to the core business of the company.

Investors prefer a consistent (and preferably increasing) regular dividend pattern, and building up a good track record in this respect can help a company achieve confidence in the management team which translates into an increased share price. Indeed, accounting earnings can be manipulated but cash dividends are cash. The level of the dividend payout ratio would typically be determined after examining the stage of the company’s life cycle. Mature, established business would have far higher dividend payout ratios than start-up or fast growing companies (which may not pay dividends at all for several years).

In industries which are cyclical or in the event that an unusual gain is realised by the company which is unlikely to be repeated, it
makes sense to return the surplus funds to shareholders by manner of a special dividend. The occasional use of a special dividend allows the company to maintain a consistent regular dividend history, without sacrificing the flexibility of maintaining an optimal capital structure.

Several companies which had historically been consistent regular dividend payers and decided to forego or reduce such a dividend (BP and Anglo American come to mind), have seen their share price decline following such an announcement, not necessarily because of the cash retention but rather the signal sent to the market that senior management and the directors foresee difficult times ahead and are choosing to retain the cash. This uncertainty about the future translates into a weaker share price. Dividend policy may send a signal to the market which is more powerful than the actual amount of dividend paid (or withheld), because management and the directors are the ultimate company insiders. They have intimate knowledge about the company’s affairs, and are thus effectively communicating non-public information by their dividend decisions.

Total shareholder return

According to Standard & Poor’s, the dividend component was responsible for 44% of the total shareholder return of the last 80 years of the index. Our internal research reveals that, measured over a 10 year period on the JSE, the equivalent statistic is 36% in dividends.

Thus, to the investor, dividends constitute a significant portion of their investment return.

Conclusion

Empirical studies have not provided a conclusive link between dividend policy and valuation. The chief consideration in determining a suitable dividend payment policy should be the availability (or lack) of suitable reinvestment opportunities which have a positive net present value (NPV). If such opportunities exist, the company should reinvest its surplus funds into these projects, failing which the cash should be returned to shareholders by way of a dividend. As an alternative, a share buy-back could also be considered if the company’s shares appear undervalued.

Article compiled by Johann Rawlinson (Senior Manager at Deloitte Corporate Finance) and David McDuff (Partner at Deloitte Corporate Finance).

Filed under: Executive Leadership, Financial Services, dividends, equity vallue, Investment, shareholders, Valuation

The $50 billion Facebook conundrum

 

Over the last few  months you will have undoubtedly come across articles in the Financial Mail or other financial magazines reporting on mind-boggling valuations for social media companies such as Facebook, Twitter, and Skype to name but a few. These “implied” valuations pegged the value of Facebook at $50 billion and the value of Skype at $8.5 billion and most recently, Twitter’s valuation of $7 billion.

Before we consider Facebook’s implied valuation, let’s look at why potential investors would like to get their hands on Facebook equity, which is currently privately held by Mr Zuckerberg and a few other select investors:

• Facebook has more than 600 million active users. If Facebook was a country in its own right, it would be the 3^rd most populated country in the world, surpassed only by China and India, each having a population of more than a billion people

• 50% of these estimated 600 million active users log on to Facebook on any given day

• The average Facebook user has 130 friends

• Facebook users spend over 700 billion minutes per month on Facebook, which translates into each active user spending approximately 55 minutes daily logged on to the social media site.

These numbers are quite astounding, but how do these figures translate into revenues and ultimately investor returns, especially given the fact that registration and actual usage of Facebook is free of charge?

It all comes down to one word- “advertising”. To an advertiser, the ability to specifically target its potential customer base is more important than blanket advertising.

Consider the following scenario: when you create your “free” Facebook account you divulge personal information such as your age, relationship status, current employer, current hometown, music and movie interests among other information. As an advertiser having access to this information is invaluable as it allows you to launch an effective, targeted advertising campaign to your potential market.  So, for example, you could target your advertising to say: single males between the ages of 27 to 35 who reside in the Sandton area, which would imply a higher earning potential, all of whom share a common love for a luxury German sports saloon.

The ability to effectively target your likely customers presents a higher return on advertising spend than a campaign that might reach a greater audience that may or may not include your potential customers.

The recent suspects

During May 2009 Digital Sky Technologies acquired a 1.96% stake in Facebook for $200 million. This would imply a valuation of roughly $10 billion for a 100% stake in Facebook (ignoring a control premium).

As recently as January 2011, investment banker Goldman Sachs acquired a 1% stake in Facebook for $500 million. This would imply an equity valuation of $50 billion for a 100% stake in Facebook (ignoring a control premium). This valuation appears excessive when taken in the context that revenues for Facebook for 2011 are estimated to be roughly $2 billion.  This implies a 25 times revenue multiple.

Aswath Damodaran, a professor of finance at the Stern School of Business at NYU and a world-renowned valuation expert raises the following two major concerns to bear in mind when looking at these transactions and their implied values in isolation, viz:

Question 1: Can one extrapolate from a single transaction amount to an overall value?

Answer (a): Yes, as long as the transaction is at arm’s length and all that you are getting for your investment is a share of the equity in the company.

Answer (b): It is possible that Goldman Sachs might stand to gain from the following additional benefits that through extrapolation could result in a misleading estimate of value:

• Investment opportunities for Goldman’s clients: As part of the deal, Goldman will be raising $1.5 billion from its clients to invest in Facebook. While this may seem to be a favour that Goldman is doing for Facebook, the reality is that Facebook is a hot company to invest in and this will allow eager investors an exclusive entrée into the company.

• A front seat for the Facebook IPO: If at some point in time, Facebook decides to go public, Goldman is likely to be the lead underwriter and reap a big share of the commission.

• Private wealth management services to Facebook’s potential billionaires and millionaires: When Facebook goes public, Mark Zuckerberg and a number of other executives will have the capacity to sell their shares in the market. While the wholesale cashing out of equity positions immediately after the IPO is unlikely, it is likely to happen over time, at which point these very wealthy individuals will need some private banking help and Goldman will be there to provide that help.

Question 2: Why would a company worth billions choose to stay private, when it clearly has the option to go public?

Answer: Conventional wisdom has always been that companies like Facebook should get a more favourable response from offering shares in the public market place than from private offerings to venture capitalists and large investors, but yet Facebook remains reluctant to go public. Damodaran believes that the following reasons, rational or otherwise, might be why Facebook is holding back with the IPO:

• Extending the tease: Based on the favourable publicity that Facebook has got from the Goldman deal, it does not look like waiting to go public is hurting Facebook, at least for the moment. In fact, it may be making Facebook an even more desirable investment to those who cannot invest in it right now.

• “Proprietary” information: While this might not be a big factor for Facebook there are some companies that choose to stay private because they are afraid of revealing proprietary information about their products/services to the general market. Instead, they can provide the information, with sufficient restrictions on disclosure, to a few wealthy investors who can then invest in the company.

•  Founder idiosyncracies: If the founder and majority shareholder in a company decides that he does not want the company to go public, the company will not go public. In the case of Facebook, it is entirely possible that Mark Zuckerberg has decided that he does not want to take the company public and he does not seem the kind of person who can be dissuaded easily.

•  Regulatory and information disclosure concerns:  From Sarbanes-Oxley to SEC restrictions, public companies are constrained in ways that private businesses are not.

• No valuation scrutiny: As a publicly traded company, no matter how well regarded it may be, the market valuation will be questioned by sceptical investors. Scaling value to earnings or book value, investors will argue that the company is overpriced, relative to other companies in the market. (Take a look at Apple, Google and Netflix, all big winners over the last year, and you will see this phenomenon at play). Facebook has the best of both worlds, at least for the moment. We get glimpses of its immense value, each time a transaction is made, and no real way to examine whether the value makes sense, since we do not have access to much of the information we need.

Is that another dot.com bubble I smell?

In a recent interview with The Daily Maverick, Antonie Roux, CEO of MIH Holdings, commented that media giant Naspers hasn’t been taking out the cheque book as often as it used to in earlier years. Roux further comments that he believes that the market capitalisation of Facebook is “unrealistic”.

This is a very interesting comment, especially considering that Naspers owns approximately 29% of DST which, in turn, is rumoured to own approximately 10% of the share capital of Facebook.

If we cast our minds back to 1999/2000 most of us will remember the massive multiples on which Technology companies were trading before the correction that subsequently followed.

As was the case with Apple and Amazon that survived the previous correction, a few companies will emerge as winners from the looming correction, but undoubtedly there will be more technology companies that won’t be as lucky as the select few.

In conclusion, the true value of Facebook will only become apparent once it files for an IPO. Subsequently the value of the shares will be dictated by the price that a willing buyer and a willing seller is prepared to pay for the share on the open market. Until then, we will be waiting with bated breath,

Article compiled by Burger Nieuwoudt (Manager at Deloitte Corporate Finance) and Suvir Rambritch (Associate Director at Deloitte Corporate Finance)

References:

Aswath Damodaran blogspot – Musing on Markets, The Facebook valuation!

The Daily Maverick – “Antonie Roux on Naspers’ success – and the new tech bubble” 27 June 2011

Filed under: Executive Leadership, Financial Services, Corporate Finance, Facebook, IPO, Skype, social media, Twitter, Valuation