Dividends Not So Discounted

8/8/2019 Dividends Not So Discounted

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This sales note is produced by Nomura Equities and is not Nomura Research. For Institutional Clients only; US Institutional Clients should contact Andre von Riekhoff (+1 212 667 1253) or their NSI sales representative.

GlobalEquity-Linked: Delta One 30 April 2010

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Dividends not so discountedIn this note, we examine the divergence in the dividend curves of the SX5E and the UKX. Through the lens of a version of the dividend discount model, the SX5E dividend curve in our view looks too high and the UKX dividend curve too low. We back this up with a study of the yields and payout ratios on both indices.A counterview comes from the analyst-based bottom up which seems to suggest the current market trading levels move in the other direction. However, for this it seems that significant dividend increases are required by the analysts from the banks and telecoms on the SX5E. While this is not impossible, we are sceptical given the current regulatory and sovereign-exposure uncertainty surrounding banks, and the already high yields on telecoms.

Idea: Buy 2012 UKX dividends, sell 2012 SX5E dividends

Idea: Buy SX5E spot, sell SX5E dividend curve from 2012 onwards

SX5E vs UKX: Dividend discount model

Essentially, the model is well known; the value of an equity should be equal to the risk adjusted present valueof future dividend flows. An adaption of this point would be that the value of an equity should be at least therisk adjusted present value of future dividend flows and at most the risk adjusted present value of futureearnings. This is to allow for the distribution of investors who are on one end more interested in receivingdividends to the other end those investors who are interested in controlling the earnings. A more detailedaccount of the model is given in the appendix.

Applying this model to the UKX and SX5E dividend curve leads to the conclusion that there is a misalignment

of approximately 20% between the UKX dividend curve and the SX5E dividend curve – see the graphs below.Assuming the model is applicable, the conclusion is that at least one of the following markets is out ofalignment; the interest rate market, the equity market, or the dividend market.

If one assumes that the probability that a market is well priced is in proportion to the amount (and notnecessarily quality ) of money invested in the market, the conclusion is that it is probable that it is the dividendmarket and only the dividend market that is not well priced.

For extra precision, one could short the UKX spot and go long the SX5E spot. For those who wish to consideran interest rate leg to this trade, as ever, please call for bespoke solutions

SX5E: discounted dividend curve (implied spot) vs spot UKX: discounted dividend curve (implied spot) vs spot

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2005 2006 2007 2008 2009

Implied Spo t

Spot

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2005 2006 2007 2008 2009

Implied Spot

Spot

Source: Bloomberg, Global Equity-Linked Source: Bloomberg, Global Equity-Linked

MarketCommentary

Stephen CohenNeil SheppardEamonn Long

+44 207 1036073+81 3 3213 9699+44 207 1038586

Vincent Li +852 2252 2494

Little margin for error

Close to max misalignment



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* Note that typically one could expect the spot should be above the discounted dividends to allow for the possibility of takeovers and speculation. In any event, thespot should not be below the present value of the dividends.

Misalignment

As the graph on the leftdemonstrates, the curvesare out of alignment. Insofaras the dividend curves areconcerned, there are twomain possibilities: (i) theUKX dividend curve is toolow relative to the SX5Ecurve; (ii) the SX5E dividendcurve is too steep relative tothe UKX dividend curve. It ispossible to argue that bothare correct. However, it isargued below in the payoutratio section that that it isthe UKX dividend curvewhich is too low.

Details to bear in mind regarding the discount model

To trade the misalignment as per the dividend discount model, one would need access to significant liquidityon the back-end of the dividend curve. Secondly, the forward interest rate curve is perhaps unusually shaped – having a peak around 10 years at 5% before decreasing gradually to around 3.5% at the 30 years.

An explanation for some of the misalignment in the dividend discount model between the two indices could bethe greater probability of takeovers occurring on that index.

The reason that one would not recommend trading shorter dated dividends on an index versus the spot isbecause of the “pull to realised” effect. For example, approximately 75% of the dividends referred to in the Dec11 contract are in respect of Dec 10 earnings, approximately 50% of which would be known by Aug 10.

Payout ratio analysis: Seems to confirm the dividend discount model picture

To calculate the payout ratio for future dividends, divide the dividend future by the earnings estimate for theindex (i.e. an index level aggregate of the earnings estimates of the individual companies).

The implied payout ratios of both the UKX and SX5E are broadly similar (within 3 percentage points) for the2010 through 2012 dividend futures. The average realised payout ratio on the UKX has been close to 20percentage points higher than that on the SX5E, generally owing to the greater preference of UK investors fordividends. Please see the graphs below.

If the analyst earnings are correct and the 2012 payout ratio were the historical average, this would mean a70% upside for the UKX while a 17% upside for the SX5E from the current levels, i.e. the 2012 dividend swapon the UKX would outperform the 2012 dividend swap on the SX5E.

Such a large discrepancy merits close but sceptical attention. It is possible to argue that the analyst earningsestimates are significantly inaccurate. Such an argument could apply on absolute basis, but it seems difficult to

Ratio of discounted dividends to spot for both the UKX and SX5E. In blue isthe SX5E ratio less the historical maximum distance between the UKX and

SX5E ratios. For the purposes of calculating maximum distance, data around

the time of the Lehman bankruptcy is excluded owing to the extreme market

distress

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2005 2006 2007 2008 2009

UKX SX5E

Source: Nomura Equity-Linked, Bloomberg

Currently close tomaximum misalignment



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argue this on a relative basis between the UKX and the SX5E. There is some precedent for anoutperformance of this size; between 2004 and 2007, dividends on the SX5E outperformed dividends on theUKX by 35%.

The projected payout ratio on the UKX (dividend swap

divided by the earnings estimate for the index) are

significantly lower than the historical average ...

While the project payout ratio on the SX5E, which is in

line with that of the UKX, it is also in line with the

historical average

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250%

2000 2003 2006 2009 2012

UKX Index Payoutratio

Historical Average

Projected

Source: Bloomberg, Global Equity-Linked Source: Bloomberg, Global Equity-Linked

Implied dividend yields: Further evidence of dividend misalignment

The implied dividend yield on an index is the ratio of the implied dividend level to the current spot price of theindex. For example, the 2012 implied yield on the SX5E is the 2012 implied dividends (eg from the dividendfutures) divided by the current spot price of the index.

Rolling 5 year yield on the UKX versus the 5 year forward

rate on the pound. The two asset returns appear to be in

line.

Rolling 5 year yield on the SX5E versus the 5 year forward

rate on the Euro. There appears to be a discrepancy.

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Jun 06 Mar 07 Dec 07 Sep 08 Jun 09 Mar 10

Forward Rate

5 Year Yld (RHS)

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5.5%

Jun 06 Mar 07 Dec 07 Sep 08 Jun 09 Mar 10

Forward Rate

5 Year Yld (RHS)

Source: Global Equity-Linked Source: Global Equity-Linked

0%

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2001 2004 2007 2010

SX5E Index Payout ratio

Hist AverageProjected



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Implied dividend yields are a useful measure of comparing the implied returns on assets. The idea is that, insome sense, the expected income from equities should move with the expected income from bonds, equities

being comparable to deeply subordinated perpetual debt. In the graphs below are plotted the rolling 5 yeardividend yield on the SX5E versus the 5 year forward rate on the Euro as well as the rolling 5 year dividendyield on the UKX versus the 5 year forward rate on the Pound. The graphs seem to indicate that the yield onthe SX5E is too high (or the 5 year forward rate is too low).

Put another way, there would appear to be more upside in the SX5E spot than in the dividend curve; acomplete reversal of the situation one year ago following the post-Lehman asset liquidation. However, theUKX dividend curve would seem to remain at the same relative cheapness to the spot as it was one year ago.

The conclusion from the yield based study is the similar to that of the dividend discount model; longer-datedSX5E dividend yield is too high relative to longer-dated UKX dividend yield.

The counter view: Analyst based bottom-up indicate more upside in SX5E dividends

The analyst based bottom up is an index level aggregate of consensus analyst dividend estimates for theindividual companies. Typically the estimates are collated out to three years to estimate the yearly dividendson the index

Implicitly, it relies on the notion that, while analysts may be biased on individual companies, on an aggregatedbasis, the individual biases should cancel out. However, this assumption would seem tenuous in the face of anunstable macro environment, or if a few large companies dominate the dividend payment on an index. Ausually smaller effect is the index rebalancing over time.

Analyst based bottom up shows a 23% upside to the

SX5E 2012 ask...

Whereas the bottom up shows a mere 14% upside to

the UKX 2012 ask

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2009 2010 2011 2012

Bottom UP

Offer

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Bottom Up

Offer

Source: Markit, Global Equity-Linked Source: Markit, Global Equity-Linked

As the graphs above illustrate, there would seem to be less upside left in the 2012 UKX dividends than in the2012 SX5E dividends.

Drilling down further, it looks as though approximately 60% of the forecast increase between 2012 and 2010 ofthe dividends is expected to come from financials and telecoms. Given the high yields of telecoms (around7%), the current regulatory environment surrounding banks, as well as potential problems with sovereign Eurodebt, it might be prudent to discount significantly these forecast dividend increases.

Whereas the UKX, being more internationally focused, and less dependent on Europe and financials, standsto benefit more from a global recovery as well as macroeconomic trends favouring basic resources and energystocks.



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Dividend increases forecast from high-yielding stocks – better to be long the stock?

It could well be that the analyst forecasts are accurate, or even not sufficiently bullish for the dividends. Indeed,in Mar 09, the analysts were forecast roughly 120 for the 2010 SX5E dividend futures, while the futures weretrading around 55. It is clear then that the analysts were – with hindsight – significantly more accurate than themarket prices. This might be viewed as supporting those who believe that the bottom up approach is notwithout validity.

The recent Q1 earnings surprises would seem to indicate that 2011 dividends could surprise on the upside.However, the 2012 SX5E bottom up predicts another 11% increase on SX5E dividends on top of the 2011SX5E dividend increases. Motivated by this, it seems to be worthwhile investigating further the 2012 SX5Ebottom up of analyst dividend estimates which is predicting a yield of 4.7% on the current SX5E price (ascompared to a forward rate of around 2%).

Forecast dividend point increases between 2010 and 2012 as

percentage of the 2010 SX5E implied dividend level plotted

versus yield. It might be surprising that an increase of 3.2

dividend points is expected from stocks yielding over 7%

Forecast dividend point increases between 2010 and 2012

as percentage of the 2010 UKX implied dividend level

plotted versus yield. The UKX does not seem to have the

same high yielding outliers

0.0%

0.5%

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0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

Significantincreases forecastfrom already highyielding stocks

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0% 2% 4% 6% 8% 10% Source: Bloomberg, Markit, Global Equity-Linked Source: Bloomberg, Markit, Global Equity-Linked

The approach is to examine which of the SX5E forecast dividend increases are coming from high yieldingstocks and calibrate this versus the UKX dividend forecasts. For the purposes of this comparison, bankdividends are excluded because of the political complications mentioned above. For the record, the latestMarkit based bottom up shows a forecast increase of 7.7 index points of dividends coming from the banksector on the SX5E between 2010 and 2012. Curiously, an increase of 7.7 index points in dividends is alsoforecast from banks on the UKX between 2010 and 2012. However, the UKX dividend future is about twice the

level in index points as that of the SX5E. In both cases, one might expect that these dividends would bediscounted with more risk than the rest of the dividends on the indices.

The results of the comparison seems to boil down to that the forecast dividend increases from the telecomssector (yielding 7% plus) on the SX5E seem to be a little diff icult to justify. Indeed, if the telecoms can fund at therisk free rate + 100 bps or lower in the debt markets, it would seem remiss of management to keep paying risk freerate + 350 bps or more in the equity markets. In other words, instead of paying all of the dividends in cash, if theseshares do not rally, SX5E telecoms management would be appear to be better advised buying back the sharesinstead of distributing the extra cash above the cost of debt funding .



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Appendix

More on the dividend discount model

The spot price should be at least the present value of the dividends

The approach is to assume that the price of any security should be between the risk-adjusted present value ofall future dividends and the risk-adjusted present value of all future earnings; i.e. between the price that apassive investor would pay to own all future dividends and the price that an investor would pay to control anduse all future earnings of the underlying.

An objection to this approach would be that it accounts neither for the intervention of speculators nor for theintervention of investors behaving irrationally. On the other hand, the disproportionate presence of either suchinterventions could be viewed as an opportunity.

Not necessary to risk adjust dividend levels, the market already does so

The phrase risk-adjusted present value is key in the above. Conventionally, one would be expected to knowthat market’s expectation of the future dividends as well as the discount rate that the market would apply toassets with that level of risk. Fortunately, the existence of the dividend swap/futures market means that it isn’tnecessary to know either as the levels are already risk-adjusted (though not adjusted to the risk-free presentvalue) by the market in which they are trading . As the dividends market is smaller than both the interest ratemarket and the market in equity indices, it is possible to argue that any misalignment is in the dividend market.

An objection to this is that risk adjustment might be greater in the dividend market than in other markets owingthe lower market size and potentially lower liquidity, and that we need to adjust for this. A response to this isthat this still means the price of a security should be higher than the present value of the dividends, as per thedividend discount model.

Calculating the present value of dividends from the dividend futures market

The approach was to take the maturities presently tradeable, and extend the dividend curve out to 50 years byassuming that the curve is flat after the last traded maturity. Normally, for the dividend discount model, it isexpected that the dividends would be known out to infinity. However, one might imagine that the expectedeconomically active lifespan of the reader would not much exceed 50 years, and that therefore 50 years maybe thought of as infinity for these purposes. As discussed already, the present value would be found bydiscounting the dividend curve by the risk-free interest rate curve.

2012 to 2015 Steepener on the SX5E: the market doesn’t seem to tolerate flat implied growth for very long – in addition,

these kind of trades are not trades to maturity. This seems to suggest that there is support for assuming that, beyond

currently traded maturities on the dividend curve, flat or negative implied growth would not be tolerated.

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Dec 08 Feb 09 Apr 09 Jun 09 Aug 09 Oct 09 Dec 09 Feb 10

Source: Bloomberg, Nomura Equity-Linked



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On balance, assuming a flat dividend curve from 2019 onwards seems conservative

To see how to extend the curve, note that for example, on the 19 Apr 2010, the last traded maturity was 2019and it traded at 123.6. To extend the curve out to 2059, assume that the dividends between 2019 and 2059would trade at 123.6. It turns out that this assumption is quite important because over the last year or so,between 60% and 75% of the present value of the dividend curve would come from the curve between 2019and 2059. It remains to justify as a conservative assumption taking the dividend curve as flat after 2019.

On the one hand, it is possible to argue that dividends have grown historically and therefore should continue togrow in the long run according to inflation and real growth. It is possible to counter this by pointing out that itmight be difficult to imagine natural buyers for a bullet dividend payment in 30 years – except perhaps forthose engaged in matching long-term liabilities with assets. The latter is a quite an objection, however, giventhe current predilection for buying of steepeners on the dividend curve at every dip, it seems difficult toconceive the dividend market being ready to accept a flat let alone downward sloping dividend curve. Onbalance, it seems that the assumption of a flat dividend curve from 2019 is a conservative one.

Rebalancing effect of index included in dividend swap, not in index

A potential difficulty in this kind of analysis is the fact that it is reasonably certain that the constituents of anindex will change over time. The dividend future provides for the rebalancing via the contract specifications – the future is a future on the cumulative dividends of the index in a given year where the dividends are addedday by day according to the companies in the index on the day.

However, the spot price of the index does not incorporate this effect – the spot price of the index is theaggregate price of the current constituents. As against that however, we note that the forward on the SX5E istrading at a lower level than the spot (as a function of the implied dividend yield being greater than the interestrates) and so the argument that the dividend curve is too high with respect to the spot would remain valid.



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Dividends Not So Discounted

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