Dividend Irrelevance
There are different methods of valuing a company’s stock used by analysts. However, their application varies and depends on the type of business and several other factors, which could be company-specific, industry-specific, or economy-specific. A few of the methods to value a company’s stock include Discounted Free Cash Flow (DCF), Gordon’s Dividend Growth Model, Economic Value Added (EVA), and Price-Earnings Ratio, etc. The theories related to dividend history can be grouped into two groups. The first group of theories is based on the notion of dividend relevance, and other theories are based on the notion of dividend relevance.
There are four different theories that suggest that dividends declared by companies have relevance to the company’s valuation. These theories are based on the notion of dividend relevance as they consider the dividend history of the company an important element of consideration and valuation of its stocks. These theories include Lintner Model, Signalling Theory, Agency Theory, and Tax Factor (Clientele Effect). The Lintner Model (1959) is based on empirical evidence that indicated that managers believe that investors expect stable dividend pay-out by companies, and they were reluctant to reduce dividend payments. Moreover, a company’s dividend policy is based on the company’s earnings. Managers set long-term pay-out targets and attempt to achieve those targets by increasing their company’s earnings (Correia, Flynn & Uliana 2013). The Signalling Theory states that the management of a company has more knowledge about its future and opportunities that could have a direct impact on its earnings.
The difference in information creates asymmetrical conditions in the capital market. The managers fill in the information gap between insiders and outsiders by declaring dividends. They do so to meet the expectations of investors, and it has an impact on the way of valuing a firm. Therefore, it could be stated that according to the Signalling Theory, the management uses dividends to bring stability in the stock price and also gain the confidence of shareholders. The Agency Theory is another theory, which is based on the view that investors are affected by the company’s decision to pay dividends to its shareholders. The theory states that managers work on behalf of shareholders, and they make business decisions that have a significant effect on the company’s earnings and future. There are conflicts of interest between managers and shareholders, as both may have different views on utility maximization. Managers may not always act for increasing the shareholders’ wealth and return on investment. Therefore, it could be stated that there is an agency cost involved in this relationship. The shareholders’ attempt to reduce their Cost of monitoring actions of managers and require managers to declare dividends as compensation if they want to keep their companies in the capital market (Engombe 2014). The Tax Factor states that companies pay dividends to attract a particular clientele, who are interested in receiving dividends from them. The dividends received by investors are taxed differently from capital gains. Therefore, companies pay dividends in those countries, which have a low tax on dividends as compared to capital gains.
The Dividend Growth Model (DGM) is one of the common valuation techniques used by analysts, which is based on the company’s historical dividends. It is based on the assumption that dividends paid by a company affect its stock value. The company’s future share price is calculated by using the following formula.
P1 = D0(1+g) / Ke – g
Where,
- P1 = Stock price in the next period;
- g = estimated growth (constant);
- Ke = cost of equity;
- D0 = Dividend paid by the company in the last period.
The company’s cost of equity represents the cost of internal funds. It is also considered as the opportunity cost that the company has to let go by investing in a particular project. The Capital Asset Price Model (CAPM) is used for calculating the cost of equity. It considers the market return, risk-free rate, and stock risk. Therefore, it contradicts with the assumption of Modigliani and Miller’s theory of dividend irrelevance, which is discussed in the following.
All these theories imply relevance of dividends for valuation of a firm. However, they have limited empirical evidence and support. Their implementation and implication are not consistently observed in different capital markets, and even in the same capital market, varying results have been noticed.
On the other hand, Miller and Modigliani (1961) proposed a dividend policy that is based on the dividend irrelevance notion. The two theorists, Franco Modigliani and Merton Miller, present this theory by suggesting that dividends and capital gains from a company’s stock are equivalent in terms of the return on investment that shareholders calculate for their equity. The theory does not support the company’s valuation on the basis of its historical dividends. The theory is of the view that investors do not consider the dividend history when valuing a company’s stock. According to this theory, the valuation of investors’ holding of the company’s stock is based on its earnings, which are based on the decisions taken by the management and also, the prospects of business (Bradford, Chao & Zho 2013).
The investors consider this investment information provided by companies to value their investments and make their decisions accordingly. They do no rely on the company’s dividend policy to measure the return on investment. The theory of dividend irrelevance could be explained on the basis of a real example. It is also argued that the Modigliani & Miller Model provides solutions for valuation in situations where the dividend history is not relevant. The theory suggests that investors can generate cash from their holding of shares depending upon their needs. If investors require cash more than dividends, then they can do so by selling the company’s shares. Moreover, when investors do not require cash, they can use the dividend amount received to purchase more shares of the company. In this way, the Modigliani-Miller Model states that the dividend policy of a company does not affect decisions of shareholders to invest or withdraw their investment from the company’s shares.
The Modigliani-Miller (1961) Model can be used to calculate the price of a company’s stock in the next period by using the following formula.
P1 = P0 x (1+k) – D
Where,
- P1 = Stock price in the next period;
- P0 = Stock price in the last period;
- k = Cost of equity;
- D = Dividend paid at the end of the last period.
Apple, Inc. did not pay dividends to its shareholders from 1985 to 2012. However, the company’s stock price increases significantly during this period. It is clear that investors were not bothered about the dividends they could have received from their holdings in the company’s stock. Instead, they were motivated and invested in the company’s stock based on its business decisions and capability of future growth in its earnings. The company’s innovative products and timely decisions made it one of the most successful businesses globally. The shareholders made capital gains from their investment in the company’s stock. They did not use dividend relevance models to value the firm. Therefore, it could be stated that Apple, Inc. is a prime example of dividend irrelevance. However, the company paid dividends to its shareholders in the last five years as criticism regarding the management’s decision to have retained huge earnings became severe.
It could be noted that the theory of dividend irrelevance as proposed by Modigliani and Miller is based on rather simple assumptions, which may not hold in reality. These assumptions include the presence of perfect capital markets, the absence of taxes, fixed investment policy of companies, and no unsystematic risk. These assumptions suggest that all investors have access to the same information and no single investor has control over the market price. Moreover, the theory suggests that dividends and capital gains have the same tax rate applicable. The investment policy of a company does not change during the investment period. It also implies that there is no uncertainty faced by the company and shareholders assume no risk associated with their investment (Miller & Modigliani 1961). The major criticism of Modigliani and Miller’s theory of dividend irrelevance is drawn from its assumptions. For example, there is no perfect market, and there are transaction costs associated with trading of shares. Moreover, it is argued that dividends do have an impact on the shareholders’ wealth (Correia, Flynn & Uliana 2013). Therefore, it could be concluded that the theory of dividend irrelevance has its major weaknesses, which make it less applicable in practical cases.
British Land Plc.
British Land Plc. operates in the UK as a real estate trust, which owns and manages valuable properties across the UK. The company’s activities are focused on developing and managing retail and office spaces. It is also involved in constructing new properties. In this section of the report, the company’s financial performance and capital structure are evaluated by using information published in its annual report for the year ended 31 March 2016. Furthermore, a detailed discussion of the risks faced by the company is provided in this report.
Risk Analysis
The management report of the company indicates that it faced several risks, which were specific to the industry in which it operates. Moreover, it was indicated that equity markets faced challenging time during the financial year 2015-16 because of macroeconomic and political risks. The REIT sector was predominantly affected by the UK’s decision to exit from Europe. The decision affected the UK property market especially in London, which also affects the value of the assets held by British Land Plc. Furthermore, the company’s management report indicated that the increase in real wages and unemployment in the country could affect its ability to grow (Annual report and accounts 2016 – British Land 2016). The company attempts to mitigate risks associated with the value of its properties through pre-letting and phasing development. There are other risks identified by the company including UK’s GDP growth, increase in the cost of borrowing, low property yields, restriction of property capital and decline in ERV growth forecast. If the country’s interest rate increases, then it would affect the company’s ability to refinance its properties. It will have to pay higher interest charges on its borrowings. All these factors can affect the company’s net asset value. There are other risks associated with the sustainability performance, which could affect consumer confidence, employment, and letting activities of the company. Furthermore, the company faces the risk of litigation resulting from the covenant breach. Lastly, the company needs to consider risks that could result from the exit of its key members (Annual report and accounts 2016 – British Land 2016).
Capital Structure
The company’s capital structure is evaluated on the basis of the values of key financial ratios provided in the following table.
Table 1. Relevant Capital Structure Data and Ratios. Source: (Annual report and accounts 2016 – British Land 2016; British Land Co PLC 2017).
Table 1 indicates that the company managed to maintain its leverage position in the last two years. It could be noted that the company’s total liabilities to equity ratio value improved slightly in 2016. Despite the increase in the company’s total liabilities including borrowings and trade related liabilities, it managed to increase its total equity, which reduced the value of the ratio. Furthermore, its debt to equity ratio value declined from 0.59 in 2015 to 0.46 in 2016. The reason for this change was the repayment of almost GBP 200 million by the company. The value of times interest earned declined sharply due to the company’s low operating profit in 2016. The management report indicated that the company’s board of director set out the borrowing level based on the earnings’ sensitivity. The company managed its cost of borrowing by adjusting the long-term fixed interest debt. However, it could be stated that the company did not have an immediate risk of bankruptcy and it has a strong solvency position. The company aims to keep the debt to equity ratio value low. The table provided above also indicated that the company had a healthy dividend pay-out ratio in both years. In 2016, the company paid 39% of its earnings as dividends to its shareholders.
Financial Performance
The following table provides values of key performance indicators of the company.
Table 2. Performance Indicators. Source: (Annual report and accounts 2016 – British Land 2016; British Land Co PLC 2017).
Table 2 indicates that the company’s revenues increased by 6%. However, its operating income declined by 27% in 2016. The reason for poor performance of the company in the last year was the company’s inability to manage its operating costs and expenses, which increased significantly. As a result, the company’s net income also declined by 20% in 2016. Due to the increase in the total equity, the value of return on equity also improved significantly. It was a positive indicator that could gain the confidence of investors. According to Modigliani and Miller (1961), shareholders are interested in the company’s earnings. Therefore, the company should focus on the implementation of effective strategies that could help it to improve its earnings.
Debt Capacity
The company’s leverage position remained strong in the last two years. It could also be indicated that the company incurred low-interest expense in 2016. The company’s retained earnings were GBP 7,667 million. Therefore, it could be stated that the company has two sources of finance including equity and debt. The company can utilize these sources of finance for its operations. The Pecking Order Theory states that companies prefer to use their internal equity. If they do not have sufficient internal equity, then the next option is to borrow from debt providers. The last option is to generate equity by issuing new shares. The choice of finance depends upon the cost of each source, which depends on various factors including accessibility to the external market. The debt to equity ratio value was 0.46 in 2016, which implies that the company could borrow more. The ratio value should not be more than 1 (one), which means that the company’s debt would be more than its equity. The company can face solvency issues if the ratio value increases. The company has strong relationships with banks and debt investors. The company is unlikely to face any problem with debt refinancing or additional borrowing. The company has access to 33 debt providers including banks and private investors. In the last five years, the company obtained GBP 6 billion of new financing through “bank arrangements, private placements, and issuance of convertible bonds” (Annual report and accounts 2016 – British Land 2016).
Recommendation
Based on the analysis performed in this report, it could be recommended that the company should increase its borrowing to finance property development and acquisition. The analysis indicates that the leverage position of the company remained strong in the last two years. Moreover, the company earned sufficient operating profit, and it did not have any problem to fulfil its debt obligations. The company also repaid a certain proportion of the principal debt amount. The company can benefit from the tax shield that could be obtained from additional borrowing. If the company increases its borrowing at low, then it could benefit from low tax payment on its profit after interest. It could be indicated that the interest expense is deducted from the company’s operating profit before tax is calculated.
Moreover, it could be noted from the company’s annual report that the company has a low cost of borrowing. Therefore, the company can advantage by acquiring additional debt at a low-interest rate. Furthermore, keeping in view the poor performance of REIT’s stocks, it is not advisable that the company goes to the capital market for raising fresh equity. However, the company must ensure that the value of the debt to equity ratio remains less than one. It implies that the company’s equity should remain more than its debt. It would ensure that the company does not face any liquidity problem, which could also affect the value of its assets. Therefore, the company needs to carefully plan and utilize different sources of finance to change its capital structure.
Reference List
Annual report and accounts 2016 – British Land Plc. 2016. Web.
Bradford, W, Chao, C & Zho, S 2013, ‘Cash dividend policy, corporate pyramid’s and ownership structure: evidence from China’, International Review of Economics & Finance, vol. 27, pp. 445–464.
British Land Co PLC ADRBTLCY. 2017. Web.
Correia, C, Flynn, D & Uliana, E 2013, Financial management. 7th ed. Juta and Company Ltd., Cape Town.
Engombe, TM 2014, Dividend policy and its impact on firm value: a review of theories and empirical evidence. Web.
Miller, M & Modigliani, F 1961, ‘Dividend policy, growth and the valuation of shares’. Chicago Journals, vol. 4, pp. 411-433.