Hey guys
I was on the phone with an analyst the other day talking about a company I was covering (it pays to network!). He said that returning cash to shareholders that the company has not earned does not create value for shareholders.
Some background:
- The company operates in a niche market
- Major player in it's business and can argue that it's a mature company (6% -7% growth)
- Has very low capital expenditure requirements
- The company has no debt
- Has a large cash balance
- Is maintaining a dividend policy above 100% of earnings
- Is paying almost all dividends with earnings + cash in balance sheet
- Has been increasing it's accumulated deficit balance for a couple of years, effectively reducing the equity stake in the company.
Can someone provide some clarity on this, good or bad? I would argue that the company is simply returning cash that it isn't using back to shareholders. It's obvious that this policy isn't sustainable in the long run.
If anyone needs anymore info, I can certainly provide it!
Thanks
It may not create value, but it may prevent value from being destroyed. If the company is sitting on cash right now there are only a few things that can happen:
1) Retain the cash / capital -- depending upon the company's reinvestment opportunities, this may or may not be a good thing. You indicated that the company has low CAPEX requirements, which tells me the company does not need to retain capital, so this is not an attractive option.
2) Buy another company -- often value destructive in my experience, since companies generally overpay.
3) Pay it out as dividend or share repurchase -- the best move assuming the company does not have attractive (ROIC>WACC) investment opportunities.
Dividends and share buybacks do not create value, but they can help shareholders realize the value that is extant.
models and bottles said it perfectly, but I'd like to touch on it a bit just because it may be even more clear for you.
If the company is paying out more cash to its shareholders than earnings provides, it is effectively destroying value in the company. Equity prices may spike on the announcement of a dividend, but since cash is leaving the company, the stock price should theoretically drop by that exact amount when dividends are paid. What happens to the stock price between announcement and ex-dividend could be anything. This is all from the company's point of view though.
From an investor's point of view, you are receiving value from the company (ie., there is a transfer of value from the company to the investor). This still may be null if the value of the stock price does fall an amount equal (or worse if greater) than the amount of the dividend.
As an equity research analyst, you make a recommendation based on the expected return, right? You have to determine an expected stock price, perhaps using DCF, and then incorporate that PLUS dividend payments to your expected return calculation to determine the overall return.
please elaborate how: 1. Company's got no debt 2. Company's got negative retained earnings ("accumulated deficit balance") 3. Company's got large cash balance to pay out as part of its total dividends.
So...are you saying the company's cash is "financed" by short-term, non-debt liabilities? this doesn't make any sense.
also, what do you mean by "Has been increasing it's accumulated deficit balance for a couple of years, effectively reducing the equity stake in the company" the company would only "reduce the equity stake" if it's taking on additional equity. Is that what's happening? they are raising equity financing and paying out the cash to shareholders as dividends? if this company is raising equity financing as cash and just paying that cash back (plus cash flow from business operations) as dividends that makes 0 business sense.
I read this as a the company operates under a subscription model, and the sharholders' deficit is a function of paying out cash received via deferred revenue as a distribution to shareholders prior to revenue recognition.
models_and_bottles - I think you nailed it, thank you for that detailed explanation
CDNdude - 1. The company has never taken out debt or financed any projects. Instead the company generates strong cash flows, requires little capital investment and small working capital/maintenance capex
2/3. The deficit is simply a function of how retained earnings is calculated (RE beg + NI - Dividends = RE ending). If the company continues to payout the dividends in excess of net income then for the balance sheet to "balance" then we need to subtract from the Asset section, ie cash. I'm sure you knew this already.
I should reword that statement. The company has been running a larger deficit each year because of it's dividends ie Year 1 : -1000 Year 2 : -2000
This results in the total stockholders' equity to decrease, which results, (my interpretation may be wrong), in the value that the equity holders own to decrease.
As far as the cash being "financed" by short-term and non debt liabilities - the company does this but to a very small extent. The company has the ability to "wipe out" all liabilities with cash and still have cash left over
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