Session 26: Dividend Policy - Assessment

In session 26 of this 36 session corporate finance class, I'd like to introduce a way of measuring how much your company can return to its stockholders in the form of dividends. I'm going to call it the free cash flow at equity, but think of it as potential dividend, a number you can compare to what a company actually does return to its stockholders, either as dividends or in the form of stock buybacks. These last few sessions, we've looked at setting up the dividend policy judgment, the dividend principle. In this session, I'd like to talk about ways in which you can look at a company and say, should my company or should this company be returning more in cash or less in cash? I'm going to call this the cash trust nexus, and you're going to see in a moment why I introduced the word trust into this discussion. The cash trust nexus, there are three basic steps. In the first step, I look at how much a company could have returned to its stockholders. I'm going to use a very simple measure of this potential dividend. I'm going to call it free cash flow at equity, but don't get too carried away with the name. It's a measure of what could have been returned to stockholders. The second step, I'm going to look at what companies actually do return to stockholders, either as dividends or in the form of stock buybacks. And we're going to see after the first two steps that most companies hold back cash. They return less than they can, which means that they're building up a cash balance that belongs to their stockholders. The third step, I ask a follow-up question. How much do I trust the managers of this company with my cash, I being the stockholder? If I don't trust stock managers with my cash, I'm going to ask for it back, and I'm entitled to get it back. And in order to make that judgment of whether I trust managers, I'm going to look at the company's history. How well has it picked projects? And how well has it done for me as a stockholder? Companies that have picked good projects and delivered good returns have earned the right to accumulate my cash. So let's get the process started. Let's look at what the companies that we're looking at have actually returned to their stockholders. So I'm going to start with Disney. And if you take a look at Disney, over the last five years, it's paid out dividends of roughly $4.5 billion. That's a lot of dividends, right? But in addition to those dividends, Disney's bought back almost $15.4 billion worth of stock. Collectively over those five years, Disney has returned $19.9 billion to its stockholders. If you look at Valet, Valet does have some stock buybacks, but it's returned far more in the form of dividends than it has in terms of buybacks. And with Tata Motors, Baidu, and Deutsche, almost all of the cash has taken the form of dividends. That is not unusual. If you remember in the last session, we talked about how US companies have increasingly turned to buybacks. And you see that phenomenon play out with Disney. Now, of course, you might ask, $19.9 billion, too much cash to too little cash? Well, we're not quite ready to answer that question yet, but at least we have a sense of how much our companies have returned in the form of cash to their stockholders. Now let's look at how much they could have returned. To measure how much a company can afford to return to its stockholders, I'm going to come up with a measure that I'm going to call free cash flow equity. Sounds fancy, right? But here's what I'm going to try to measure. I'm going to look at the cash leftover after you've met every conceivable need as a company. So let's see how I'm going to build up to it. I'm going to start with the net income because after all, that is the accounting income to equity investors. I'm going to add back depreciation and amortization. Why? Because it's an accounting expense. It's not a cash expense. Then I'm going to start subtracting out every single need that I have. Capital expenditures, principal payments, working capital needs. Well, some of these needs I might cover with new debt issues. So that's a positive cash flow. But what I'm left with at the end is called the free cash flow equity. When you do this for a company, you could end up with a negative free cash flow equity. And if you do end up with a negative free cash flow equity, your dividend assessment just got very simple. A company with negative free cash flow equity should really not be returning cash to its stockholders, right? Because you're already in the hole. And the rule, if you're in a hole, is stop digging. So if the free cash flow equity is negative, don't pay dividends, don't buy back stock. If it's positive, that is what the company could have returned in that particular year, either as dividends or stock buybacks. So that's the way we come up with potential dividends. Let's try this for Disney. I took the same five years over which they returned $19.9 billion. And I tried to estimate the free cash flow equity each year. I took the net income. I subtracted out net capital expenditures, which is really the equivalent of adding back depreciation and subtracting out capex. I subtracted out change in working capital. I come up with a free cash flow equity before I consider debt payments. And that amount for Disney was $17.3 billion. So without considering cash flows from or to debt, Disney could have returned $17.3 billion. If I allow for the fact that their debt ratio is 11.58%, that means some of their net capex and change in working capital should be funded with debt, the free cash flow equity rises to $18.1 billion. What does that tell me? Well, during this five-year period, if Disney wanted to maintain their debt ratio at 11.6%, they could have returned $18.1 billion across the five years. You say, why aren't you looking at the individual years? Because strange things can happen in individual years. Working capital can increase, it can decrease. So I'm looking across time to get some sense of a normalized value. $18.1 billion is what they could have returned. What they actually returned was $19.5 billion. So in a sense, they returned more cash than I expected them to over the period of $19.9 billion. They returned $1.8 billion more cash than they could have given their free cash flow equity. For the moment, that's neither here nor there, but it's a very simple starting process for assessing dividend policies to compare what gets actually returned to what could have been returned. If you take a look at the free cash flow equity computation, it's pretty complex, right? Lots of line items. You got capex, depreciation, working capital, debt in, debt out, principal repayments. Now there is a simpler version of free cash flow equity, but to use a simpler version, you have to be willing to make an assumption. If you're willing to assume that you have a stable debt ratio, a debt ratio you're going to use to fund future reinvestments, and that's what you're going to use to fund net capex and change in working capital, here's a shortcut that works. You start with a net income just as you did before, but instead of going through the entire process, here's what you do instead. You subtract out the equity portion of your net capex. So let's say your debt ratio is 20%. You subtract out 80% of your net capex and 80% of your change in working capital. What, in effect, you're doing is you're subtracting out only the equity portion of what you have to reinvest. You're going to come up with a free cash flow equity. This is an alternative approach. It's a simpler approach, but to use this, you've got to be willing to make the assumption that your debt ratio is stable. What you're, in effect, also assuming that when principal repayments come due because you want to maintain a stable debt ratio, you repay that old debt with new debt because if you repay it with equity, your debt ratio will decrease. So two ways of estimating free cash flow equity. Make your choice based on your assumptions about the debt ratio. Let's try this approach, this simplified approach for Microsoft in 1996, way back in time. But in that year, Microsoft had $2,176 million in net income. It had relatively little net capex and change in working capital. The reason its net capex is so low, its biggest capex is actually R&D, and that was already netted out to get net income. If I subtract out the net capex and change in working capital, allowing for the fact that Microsoft did not use debt in 1996, their free cash flow equity is $2,127 million. You say, what does that tell me? In 1996, Microsoft could have afforded to return $2,127 million to their stockholders. You know what they actually did? They paid no dividend. They bought back no stock. So I have a question for you. If they could have returned $2,127 million and they chose not to return a single dollar, where would I find this $2,127 million on Microsoft's balance sheet? Think about it. Now, some of you are probably saying, well, I'll see it in retained earnings. Wrong side of the balance sheet. It should be in the asset side. In fact, you know where it's going to end up? It's going to show up as an increase in your cash balance. Why? Because remember, this is after capex. It's after R&D. It's after working capital needs have been met. The only place left for it to go is into a cash balance. In 1996, Microsoft's cash balance increased by 2.1 billion. In 1997, increased by another 3 billion. In 1998, increased by 5 billion. And remember, each year, this increases on top of the prior year's cash balance. Your cash balance is building up. By 2001, Microsoft had the largest cash balance in the world. And one way it got there was year after year, it systematically held back cash. What I'm trying to say is when you see companies with large cash balances, it does not happen by accident. It's a deliberate effect of dividend policy. If year after year, you hold back cash you could have returned, your cash balance will increase. Now, of course, what happens afterwards is a different issue, but that's the way companies end up with big cash balances. So the free cash flow equity is a very useful device for figuring out what you can afford to pay out in dividends. Now, let's suppose you were looking at a bank. Can you compute the free cash flow equity for a bank? Well, if you use the traditional way of estimating free cash flow equity, it's very difficult to come up with a free cash flow equity for a bank because defining capex, a working capital for a bank, is a nightmare. So here's an alternative. If you want to come up with free cash flow equity for a bank, redefine what you mean by reinvestment. Rather than think of reinvestment as going to land, building, equipment, and working capital, think of reinvestment as what the bank has to put into its regulatory capital to grow. Because remember, banks operate under regulatory constraints. If they don't add to the regulatory capital, they cannot grow. To give you a very simple example, let's assume you have a bank that has made $10 billion in outstanding loans. And let's suppose its regulatory capital ratio is 7.5%. Let's say it expects to make $150 million in net income next year. And let's also assume that it expects its loan outstanding to go from $10 billion to $11 billion. Let's figure out what this bank will have as free cash flow equity next year. First, remember that the increase in the loan outstanding from $10 billion to $11 billion with a 7.5% regulatory capital ratio will mean that they have to come up with an extra $75 million in regulatory capital next year, right? They have $150 million in net income. They've got to set aside $75 million to regulatory capital. That'll give them a free cash flow equity of $75 million. That's what they can afford to pay in dividends. Now, of course, with a regular bank, with a real bank, especially if it's a money center bank like Deutsche Bank, it's a much more messy process. But the principle remains the same. I can start with net income at Deutsche Bank, estimate how much they will need to reinvest in regulatory capital, which will require that I make assumptions about growth in their asset base and what they want their regulatory capital ratio to be. Subtract that investment in regulatory capital or increase in regulatory capital from my net income each year, I'll get a free cash flow equity each year. I can use this as my basis for estimating what banks can pay out as dividends or use to buy back stock. So you can estimate the free cash flow equity for a financial service company. You just have to take a different route to get there. But now let's look at the bigger picture. So you have dividends, which is what companies actually return and free cash flow equity, which is what they can afford to return. At the start of every year, I take every company that has a market price, which pretty much includes every publicly traded company in the world. And I compute the free cash flow equity for every company and what they return to stockholders in the form of dividends and buybacks. And then I categorize companies into five groups and I'll break. And as I go through each of these groups, think about whether these groups are doing what you'd expect them to do. The very first group in this, in the sample are companies with negative free cash flow equity that pay no dividends. It makes sense, right? If you have negative free cash flow equity, you shouldn't pay dividends. The second group of companies which have free cash flow equity, which are actually positive, but which are negative, but pay dividends. Now think about it. You have a negative free cash flow equity, you're paying dividends, you're making the hole deeper. So this group of companies is doing something you would not expect to see them do. They have negative free cash flow equity, but they're paying dividends. The next group has a similar problem. They have positive free cash flow equity, but they pay out more than that free cash flow equity as dividends. So you sum up these two groups. These are the companies that pay out more in dividends than they can afford to for whatever reason. The last two groups are companies that pay out less than they can. In fact, the first of those two groups has free cash flow equity, which are positive, but pay no dividends. So they're building up cash. And the second of those two groups has positive free cash flow equity, but pays out less than the free cash flow equity as dividends. So that's building up cash as well. So across these five groups, the first group, negative free cash flow equity, no dividends, makes sense. The last two groups are building up cash. The middle two groups are actually building down cash. So it's worth noting, because if you look across companies, not all companies do what you'd expect them to do based on the free cash flow equity. Now, the consequences of not paying out what you can afford to pay out in dividends, paying out less than your free cash flow equity, as we noted, is a buildup in cash balance. We talked about what happened in Microsoft between 96 and 2001, as they built up to the largest cash balance in the world. Now, in 2001, Microsoft actually got off scot-free for having a big cash balance. Scot-free in what sense? There was no pressure on Microsoft in 2001 to return cash to their stockholders. But that's not always the case. Companies, when they sometimes build up big cash balances, find themselves under pressure to return the cash. And that raises an interesting question. Why do some companies get a free pass when they build up cash balances? And why do other companies come under pressure? To try to answer this question, I'm going to take Chrysler in 1994. For those of you who remember the history of Chrysler, it almost went bankrupt in the early 1980s. It got a new lease on life in the mid-80s, when it, in a sense, invented the minivan and used it to push sales and profits. And between 85 and 94, as Chrysler's profits recovered, it built up a cash balance. How? By returning less in cash than was available in free cash flow equity. In fact, its cash balance went from almost nothing in 1985 to about $8.5 billion in 1994. And in 1994, Chrysler was targeted by an activist investor, a man called Kirk Kerkorian, who argued that Chrysler had too much cash. Now, Chrysler responded by saying, we're a cyclical company. Makes sense, right? Cyclical companies, recessions might need the cash. But if you look at this time period in history, there is a recession in this time period, right? 89, 90. And during that time period, it's true, Chrysler burned through some of their cash balance. In fact, they burned through about a half a billion dollar cash balance. But you can see why this argument didn't work for Chrysler, because with an $8.5 billion cash balance, think of how big the next recession has to be for you to need that much cash. So Chrysler's second argument was they might need to do an acquisition. Another argument that didn't fly well with stockholders. In the end, Chrysler lost this argument with Kirk Kerkorian, had to pay out a big chunk of their cash balance as dividends. But the reason Chrysler came under pressure was because they were in a mature business and their returns on capital were roughly equal to their cost of capital. So what investors were saying was, you have a big cash balance, we don't trust you with the cash. And if stockholders don't trust you with the cash, they're going to ask for their cash back. In 2001, Microsoft was trusted by its stockholders with the cash because it had come off a 15-year time period where the stock price had just gone up and up and up. By 2003, Microsoft was under pressure to return cash. This does happen in companies. You can go very quickly from a company that is trusted with the cash balance to a company where that trust shifts and stockholders demand their cash back. So here's what I'd suggest you do. Take your company, go to the statement of cash flows because almost every item you need to compute a free cash rate equity is on that statement and build up to a free cash rate equity. In other words, estimate what your company could have afforded to pay in dividends. Notice that in the statement of cash flows, the signs in the cash flows already reflect whether they're positive or negative cash flows. In other words, your capex will be a negative number. Your depreciation will be a positive number. So keep the signs intact, compute a free cash rate equity. Then in the same statement of cash flows, look to see how much your company returned as dividends or stock buybacks and compare the two numbers. Make a judgment on where your companies fall in terms of those five categories. Is it a company that's returning more than it should or less than it should? It's a precursor to what's coming in the next session where we're going to ask the follow-up question. Do we trust these companies with our cash? So that's where I'm going to leave you with this session. Thank you very much for listening.