Assessed Blog 4: Morrisons pay the price for sticking with dividend policy

This week’s blog will be discussing the conundrum that is Dividend Policy. For decades the dividend decisions of management teams has been examined by empirical research, however, no entirely conclusive argument has been established to explain the  role of dividend policies on shareholder wealth.

The key principle of corporate finance is for the decision making of management to create value to the company’s shareholders. But do dividend payments have any impact on the share price of the business? This question has been debated since Miller and Modigliani’s (1961) paper, which regarded dividend policies as ‘irrelevant’. They argued that it was the future prospects and the productivity of the firm’s assets which determined a firm’s future earning potential, and therefore its share price. This argument may be supported by companies such as Apple and Microsoft who rarely pay dividends, but instead plough huge sums of money in to research and development. Shareholders are attracted to companies such as these, because of their future potential created by these large investments. Miller and Modigliani argue that investing in projects that increase the positive NPV cash flows of the firm will in turn increase their share price, increasing shareholder wealth. They conclude that residual cash left over, following the investment in positive NPV projects, should be given back to shareholders. Is this applicable to every firm, in every industry? The dividend policies of companies would suggest that dividends are actually relevant.

Morrison’s dividend policy has consisted of steadily increasing dividend payments yearly. The supermarket industry has changed drastically in recent years, with consumer buying behaviour changing considerably. Morrison’s performance has been affected as a result of this transformation of the market. In 2014, they once again raised their dividend despite their half-year pre-tax profits falling by over a third; a decision that raised many eyebrows as competitors Sainsbury’s and Tesco slashed their dividends to focus on reducing prices to the price conscious consumers (Thomas, 2014). The company chairman Dalton Phillips added to the news of the increased dividend, that the company was moving in the right direction and that the prospects of the firm were encouraging. But was this decision from the senior management of Morrison’s justified?

Figure 1:

Year	Interim	Full Year	Total
2014/15	4.03p	9.62p	13.65p
2013/14	3.84p	9.16p	13.0p
2012/13	3.49p	8.31p	11.80p
2011/12	3.17p	7.53p	10.70p
2010/11	1.23p	8.37p	9.60p

Morrisons (2015) from http://www.morrisons-corporate.com/investor-centre/Shareholder-information/Dividend-history/

6 months later and Morrison’s has announced that they are reducing their dividend payments to fund their current supermarkets. They have also suspended plans to open more convenience stores which are part of their strategy. Should the company have cut their dividend payments sooner? In line with Modigliani and Miller’s theory, Morrison’s should have not paid dividends until all of their potential positive NPV projects were invested in. Instead, they have now cut their dividend and suspended their projects. So why is this?

Since Miller and Modigliani’s seminal paper, other authors have gone on to discuss the impact on dividend policy that market imperfections such as taxation, information asymmetry and the interests of management.  In the case of Morrison’s, the clientele concept may be explanatory of their decision to offer stable dividends with stable growth. The clientele effect suggests that certain investors invest in specific firms with specific dividend payment policies. By keeping a stable dividend policy, there are likely to be no surprises that upset Morrison’s shareholders, causing them to sell their shareholding. However, is it always feasible to suggest that an investor would put stable dividend payments before the sustainability and prospects of the firm (which are more likely to create long-term shareholder wealth)? If Morrison’s had decreased their dividend sooner then they may not have had to cut back on the rolling out of their convenience stores; which may have recovered their performance sooner. After all, the wealth of the shareholders is likely to be greater maximised by the market valuation of their shares. Had Morrison’s invested in more positive NPV projects, then their future prospects may be greater, increasing the price of their shares. Had Morrison’s explored this tactic, their shareholders may have been able to replace official dividend payments with ‘homemade dividends’ from the sale of their shareholdings following an increase in share price (Arnold, 2013).

The dividend conundrum continues on from the previous argument for investing in projects that bring return in the future. By providing investors with their dividends now, this may please some investors who are against the risk of future dividends not coming to fruition. This ‘bird in the hand’ argument was made by Myron Gordon; however I see this as a poor concept that could actually stifle the long-term sustainability and performance of firms.

Morrison’s dividends are likely to have been used to convey messages. Unexpected changes in dividend amounts are likely to be perceived in particular ways by investors, because of the information asymmetry that exists between the management of the firm and the market. By maintaining the steady increase in dividend payment, the management of Morrison’s were attempting to shed positive light on the prospects of the firm. However, now they have cut their dividends is this indicating that the management are worried about the long term prospects? Despite the disappointment of the lower dividend, the move has underlined the company’s commitment to capital discipline (Hunter, 2015).  Had the company applied the same dividend policy despite a second year of decline then the message been conveyed to investors would be a very confused one.

The area of dividend policies in corporate finance has interested me a great deal. From reading the literature and studying the dividend policies of firms, I am no closer to understanding what an optimal dividend policy looks like. It is clear that dividends are relevant to the market, and company management teams must carefully consider the effects of their dividend policies. From studying Morrison’s, I believe that they were too slow to cut their dividends, and should have invested more in to the company operations and projects, before returning cash to their shareholders. This conclusion has been made with the added benefit of hindsight however, and the company may have had a large focus on the impact a decrease in dividends would have on shareholder confidence and share price.

References

Black, F., & Scholes, M. (1974). The effects of dividend yield and dividend policy on common stock prices and returns. Journal of financial economics, 1(1), 1-22. Retrieved 2nd April 2015 from Science Direct http://www.sciencedirect.com/science/article/pii/0304405X74900063

Miller, M. H., & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. the Journal of Business, 34(4), 411-43. Retrieved 2nd April 2015 from JSTOR http://www.jstor.org/stable/2351143?seq=1#page_scan_tab_contents

Richardson, G., Sefcik, S. E., & Thompson, R. (1986). A test of dividend irrelevance using volume reactions to a change in dividend policy. Journal of Financial Economics, 17(2), 313-333. Retrieved 2nd April 2015 from Science Direct http://www.sciencedirect.com/science/article/pii/0304405X86900681

Ruddick, G. (2015). Morrisons to slash dividend to fund rescue plan. Retrieved from http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/11455839/Morrisons-to-slash-dividend-to-fund-rescue-plan.html

 

Thomas, M. (2014). Morrisons raises dividend despite collapse in profits. Retrieved from http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/11088751/Morrisons-raises-dividend-despite-collapse-in-profits.html

Assessed Blog 3: Would you Adam and Eve it… Apple valued at $1trn!

In the wake of the news that Apple’s valuation has reached $1 trillion. I feel that it is an interesting time to reflect on the valuation process that corporate managers and investors undertake. The valuation process is important for management to understand the implication of factors on share price (and shareholder wealth). It is also an important technique for managers to possess for valuing merger and acquisition targets. From studying the literature and reading articles regarding company valuations, it is evident that there is a large degree of subjectivity involved in the valuation methods used. Warren Buffett described valuing a business as ‘part art and part science’.

Apple is the largest company in the world, as measured by market capitalisation (Number of Shares X Share Value). Their share price has strengthened to just under $180 as the company has significantly improved its position in the Chinese market. As well as this promising news, Apple is on the verge of launching their new product category, the Apple Watch. The market has responded positively, and as a result the firm’s market value has increased. But is this the true value of Apple? Many would argue that this $1 tn valuation is the minimum valuation of the firm. This method of valuation can only be truly accurate if the market is truly efficient, however, information asymmetry exists and management will have essential knowledge of the firm that the public is unaware of.

So how about measuring Apple by its net assets? From Apple’s latest balance sheet, an underwhelming net asset figure of around $102bn can be calculated. This discrepancy in the two calculated values is because of the Net Asset Value (NAV) method overlooking the intangible assets that Apple possess. Arguably these assets, which include human capital, brand, and goodwill, create the most value for the firm. However, their value is nowhere to be seen on their balance sheet. Valuation based on the NAV method is better suited to valuing a company in financial difficulty when a company is considering buying the firm’s asset in a liquidation situation.

A better way to measure a firm’s value would be to calculate a value based on future income…right? Gordon’s dividend growth model is one method used to calculate a share price from the present value of expected future dividends. However, there are a number of hurdles that arise when using this technique. Predicting the growth of dividend payments of a company may be difficult for firms with volatile dividend payment patterns. Even worse, Apple (until recently) have not paid dividends, making the method impossible to use.

The price-earnings ratio of companies is a popular valuation method. The historic PER compares a firm’s share price with its latest earnings (profits). Investment analysts will have an ‘appropriate’ P/E ratio level for either a share or sector, and will also consider both risk and growth factors of the company. A value for equity is then calculated by multiplying a sustainable earnings figure by the P/E ratio (Sudarsanam, 2004). Despite this method being widely used by the investment community, it still has a number of limitations. Apple is renowned for having a lower P/E ratio than expected, thus the valuation calculated may be unreliable. There is also much scepticism regarding the accuracy of earnings figures, due to the flexibility in financial reporting, allowing companies to ‘window dress’.

A Discounted Cash Flow (DCF) Valuation method would be most appropriate for Apple, in my opinion. According to Mukherjee, Kiymaz and Baker (2004), the DCF method provides the most rational framework for valuing a business. This method forecasts the future cash flows of a business (typically post-merger, calculating the effect of synergies). In the (unlikely) event that a company should pay no more than the difference between the pre- and post-acquisition cash flows.

PVa+b – Pva  = Maximum Payment

This method considers the value attributable to shareholders created by the combined entity when working to calculate a value for a target firm. Greater likelihood is that Apple would be valued by their future cash flows. To incorporate the time value of money the cash flows are discounted. Future cash flows are difficult to estimate and are influenced by many internal and external factors. Once the subjective cash flows are calculated, a cash flow per share is calculated and then divided by the cost of equity for the firm.

So how much is Apple worth? It is recommended that each of the valuation techniques is considered in full knowledge of the weaknesses that each approach holds. From this, management can then apply their informed judgement to produce an estimated value region for the entity in question. In my opinion the market capitalisation valuation of Apple is realistic. The market is well aware of the innovation and creativity associated with Apple, as well as the strength of their brand, reflected in the inflated value of one trillion dollars.  


References

Arnold, G. (2013). Essentials of Corporate Financial Management. (2^nd ed.). Harlow, Essex: Pearson Education

Eckbo, B. E. (2009). Bidding strategies and takeover premiums: A review. Journal of Corporate Finance, 15(1), 149-178. Retrieved 12^th April 2015 from Science Direct http://www.sciencedirect.com/science/article/pii/S0929119908000953

Mukherjee, T. K., Kiymaz, H., & Baker, H. K. (2004). Merger Motives and Target Valuation: A Survey of Evidence from CFOs. Journal Of Applied Finance, 14(2), 7-24. Retrieved 16^th April 2015 from http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.196.8160&rep=rep1&type=pdf

Penman, S. H., & Sougiannis, T. (1998). A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation*. Contemporary Accounting Research, 15(3), 343-383. Retrieved 17^th April 2015 from Science Direct http://onlinelibrary.wiley.com/doi/10.1111/j.1911-3846.1998.tb00564.x/pdf

Sudarsanam, S. (2003). Creating Value from Mergers and Acquisitions: The Challenges. (1^st ed.) Harlow, Essex: Pearson Education