Payout Policy and Share Valuation

Dr. Himanshu JoshiFORE School of Management

New Delhi

Payout Policy..

• Companies can payout cash to their shareholders in two ways:

• They can pay dividend or• They can buy back some of the outstanding

shares. • Payout policy explains how companies decide on

the amount and form of this payout,• and we discuss the controversial question of

how payout policy affects the value of the firm.

Payout Policy..

• Indian Companies were allowed to buyback shares from 1998. in 2004, a total of 10 companies went ahead with buyback of shares..

• Godrej consumer Products Ltd (Rs.8.4 Cr.)• Britannia Industries (Rs. 78 Cr.)• Reliance Industries Ltd. (Rs.2999 Cr.)• Once the BOD approves the company’s decision

to buyback shares, the companies informs SEBI of the decision.

The Dividend Payment Time Line..

• Dividends in publicly traded firms are usually set be the board of directors and are paid out to stockholders a few weeks later. There are several key dates between the time the board declares the dividend until the dividend is actually paid.

The Dividend Payment Time Line..

• Dividend Declaration Date: the date on which the board of directors declares the rupee dividend that will be paid for the quarter (or period).

• This date is important because by announcing its intent to increase, decrease or maintain dividend, the firm conveys information to financial markets. Thus if firm changes dividends, this is the date on which the market reaction to the change is most likely to occur.

The Dividend Payment Time Line..

• Ex-Dividend Date: at which time investors have to have bought the stock in order to receive the dividend.

• Since the dividend is not received by investors buying stock after the ex-dividend date, the stock price will generally fall on that day to reflect the loss.

• Holder of Record Date: few days after the ex-dividend date, the company closes its stock transfer books and makes up list of shareholders to date on the holder of the record date. These shareholders will receive dividends.

• Dividend Payment Date: in most cases, the payment date is two to three week after the holder-of-record date.

Announcement date Ex-Dividend Date Holder of record day Payment Date

Dividend Payments and Stock Repurchases..How Dividend Are Paid..

• A company’s dividend is set by the board of directors. The announcement of the dividend states that the payment will be made to all those stockholders who are registered on a particular record date.

• Then two week later dividend checks are mailed to stockholders.

• Stocks are normally bought and sold with dividend or cum dividend until few weeks before the record date, and then they trade ex dividend.

Dividend Policy and Regulations.

• The company is not free to declare whatever amount of dividend it chooses.

• Dividend payment by Indian companies is regulated by Sec.205 of the companies Act.

• As per the Act, a company can pay dividends out of profits for that year arrived after providing for depreciation (Sec.205 (1)) to the extent specified in Sec. 350 of the companies Act and after transferring to the reserves (Sec. 205 (2A)) of the company at least 10% of its profit for that year.

Dividend Policy and Regulations.

• Most companies pay regular dividend each year, but occasionally this is supplemented by a one off extra or special dividend. Videsh Sanchar Nigam Limited (VSNL), for example, offered its shareholders 750% special dividend before its disinvestment in December 2001.

• Dividends are not always in the form of cash. Companies can also declare Stock Dividend or Bonus Shares.

How Firms Repurchase Shares

• Instead of paying a dividend to its stockholders, the firm can use the cash to repurchase stock. As per SEBI (buy back of Securities) Regulations,1998, a company can buyback its shares by:

• the tender offer, or • from open market either through book building process or stock

exchanges, or• From old lot holders.• In India a company can not buyback shares through negotiated

deals. However, in the U.S a company can buy back shares by direct negotiation with a major shareholder.

• Most notorious transactions are of Greenmail transactions..

Dividends Denomination..

• When an Indian company announces 20% dividend it is 20% of the face value of the share. (Rs. 10*20% = Rs. 2).

• Internationally, when company a declares 20 percent dividend, it actually distributes 20 per cent of the total profit after tax to the shareholders.

Measures of Dividend Policy

• Dividend Yield = Annual Dividend per sharePrice Per Share

• Dividend Payout Ratio = Dividends Earnings

Distribution or Liquidating Dividend

• Distribution from capital is referred to as liquidating dividend.

Information in Dividends and Stock Repurchases.. Signaling Hypothesis

• In some countries (India) you can not rely on the information that companies provide. Passion for secrecy and a tendency to construct multilayered corporate organizations produce asset and earnings figures that are next to meaningless.

• How does an investor in such a world separate marginally profitable firms from the real money makers?

• One clue is dividends.

Dividends Signaling Hypothesis

• A firm which reports good earnings and pays a generous dividend is a real money maker.

• Investors would value the information content of dividends and would refuse to believe a firm’s reported earnings unless they are backed up by an appropriate dividend policy.

• Of course, firms can cheat in the short run by overstating earnings and scrapping up cash to pay a generous dividend. But it is hard to cheat in the long run.

Dividends Signaling Hypothesis

• If a firm chooses to pay higher dividend payout with out the cash flow to back it up,

• that firm will ultimately have to reduce its investment plans, or

• Turn to investors for additional capital in the form of debt or Equity.

• Debt increases the Risk profile of the company. • And Equity dilutes the per share income of the

investors.

The Information Content of share Repurchase..

• Share repurchases, like dividends, are a way to hand back cash to shareholders. But unlike dividends, share repurchase are frequently a one-off event.

• So a company that announces a repurchase program is not making a long term commitment to earn and distribute more cash.

• So information content of share repurchase and dividend policy is different.

The Information Content of share Repurchase..

• Companies repurchases shares when they have accumulated more cash than they can invest profitably or when they wish to change capital structure.

• Neither circumstance is good news in itself, but shareholders are frequently relived to see companies paying out the excess cash rather than frittering it away on unprofitable investments.

• Shareholders also know that the firm with large quantities of debt to service are less likely to squander cash.

• Comment and Jarrell, found that announcement of open market purchase programs resulted in an abnormal price rise of 2 percent.

The Information Content of share Repurchase..

• Stock repurchases may also be used to signal a manager’s confidence in the future.

• If manager, believe that his stock is substantially undervalued, he announce that the company is prepared to buy back a part of its stock at a price that is 20% above the current price. But he says he is certainly not going to sell any of his stock at that price.

• Investors jump to the obvious conclusion – Stock is good value even at 20% premium above the current price..

Factors affecting Dividend Policy

• Transaction costs: (i) Firm's Transaction Costs (ii) Shareholder’s Transaction Costs.

Shareholder’s Income Tax Dividend Cover: Profit after Tax/Dividend Dividend Signaling Hypothesis Divisible Profits Liquidity Rate of Expansion of business

Factors affecting Dividend Policy

Rate of return Stability of earnings Contractual Constraints Cost of external financing Degree of control Access to capital market General state of economy.