2023-08-16 10:31:10 ET
Summary
- Stock prices and returns are influenced by a company's net cash on the balance sheet and changes in its future expected free cash flows.
- Enterprise valuation, also known as the discounted cash flow method, is a more comprehensive way to determine a company's intrinsic value than applying valuation multiples.
- A company's share price is adjusted downward by the amount of the dividend on its ex-dividend date. Understanding this has important considerations across dividend income strategies.
- Should Microsoft pay a special one-time dividend? After reading the article, what are your thoughts on special one-time dividends? Post in the comments section!
By Brian Nelson, CFA
As a financial publisher, one of the primary goals of Valuentum is financial education. Having built and updated over 20,000 discounted cash-flow models ( white paper ) and spent time on the buyside and independent stock research for almost 20 years now, coupled with concentrations exclusively in finance and accounting in my master's program for my educational background, I've fallen in love with finance as field of continuous study. A concept recently studied by Chicago Booth's Samuel Hartzmark and University of Southern California's David H. Solomon called the free dividends fallacy continues to resonate with me. In their work, they explain that a focus on dividends could be costing investors roughly "2-4 percent less per year than could otherwise be expected." Interestingly, from an empirical standpoint, the past 10 years have supported their conclusions.
As the award-winning book Value Trap: Theory of Universal Valuation explains, stock prices and returns are a function in part of a company's net cash on the balance sheet and its future expected enterprise free cash flows. We call these two components cash-based sources of intrinsic value--that which derives a company's intrinsic value and share price. As expectations of future free cash flow increase, for example, the share price should advance. If expectations of future free cash flows decrease, the share price should decline. The world is not as simple as this, of course, as changes in interest (discount) rates, forced selling, and sometimes exogenous events can alter dynamics and muddy the waters. Nonetheless, the framework is sound. A company is generally worth more the more net cash it has on the balance sheet and the higher future expected enterprise free cash flows it generates.
Within the context of the cash-based sources of intrinsic value rests the process of enterprise valuation. Enterprise valuation is more commonly-known as the discounted cash-flow [DCF] method. The process sums net cash on the balance sheet and the discounted present value of future enterprise free cash flows to arrive at an intrinsic value of a company. This intrinsic value can then be divided by weighted average diluted shares outstanding to arrive at a fair value estimate per share of the company. This fair value estimate per share can then be compared to the company's stock price to determine whether a firm is overvalued or undervalued. If its fair value estimate is higher than the stock price, it can be considered undervalued; if it is lower, it can be considered overvalued.
Notice how the process does not make use of short-cuts to valuation, which can lead to trouble. The enterprise process does not use the price-to-earnings [P/E] ratio, price-to-book [P/B] ratio, or other valuation multiples. There is a reason why: The enterprise valuation process actually is used to derive these multiples. For example, the output of the enterprise valuation method arrives at a fair value estimate per share, and investors buy and sell shares to drive price discovery on the open market. This fair value estimate per share can be divided by any metric one desires (e.g. sales, earnings, book value, and the like) to derive the valuation multiple that should be placed on an equity. An understanding of this is important as it shows that valuation multiples do not drive the price, per se--valuation multiples are instead an output of the enterprise valuation process--and it is the components of enterprise valuation that drive valuation and share price changes.
Oftentimes, the discounted cash-flow model is dismissed as merely an academic tool, heavily dependent on the sensitivity of long-term assumptions. However, enterprise valuation and its output, the fair value estimate, is inherently tied to a company's share price, and therefore its valuation multiples. For example, reverse-engineering a company's share price via the discounted cash-flow model, one can arrive at the underlying assumptions that support the price. The astute investor may ask themselves whether such assumptions make sense. If they are too optimistic, the stock may be considered overvalued; if they may be too pessimistic, the stock may be considered undervalued. Tying the DCF-output's intrinsic value to the share price also indicates that the valuation multiple market participants may be assigning to shares is but a short-cut DCF model in this regard.
We posit that it makes much more sense to derive fair value estimates than to hastily assign valuation multiples to a company's shares. After all, the discounted cash-flow model helps investors understand the key drivers behind valuation and a company's share price, while applying a P/E ratio, for example, to a company's forward earnings makes all the assumptions of the DCF in one fell swoop, and sometimes hastily. This could lead to trouble. Remember, tying the fair value estimate to match a company's shares inherently ties the DCF to any valuation multiple. One can't escape the DCF by using valuation multiples. Because the future of the past, which determines the historical P/E ratio, is different than the future of the present, which determines today's P/E ratio, there are tremendous shortcomings in using historical averages of valuation multiples in any application, whether quantitative or in the valuation context.
With that said, let's think about the components of cash-based sources of intrinsic value within the enterprise valuation construct to further the view of its importance. We've used this hypothetical example before in this article , but it bears repeating in this work.
Let's say a hypothetical company has 100 shares outstanding and generates $1 in earnings. Its share price is trading at $100 per share, and it has no debt and no contingent liabilities or other concerns. On the balance sheet stands $1 billion in cash, however. Would you buy this hypothetical stock for 100 times earnings? You might balk, and say "No way! Not at 100 times earnings. That's far too expensive."
Well, let me tell you. If you were to buy 100 shares of stock of this hypothetical company for $100 each (as in the hypothetical example), then you'd spend $10,000 for all the assets of the firm [100 shares of stock x $100 per share], and guess what? There is $1 billion of cash just sitting on the balance sheet that would be yours. As the then-owner of the company (you own all the shares), you would also own all the assets of the firm, too. Said another way, you'd be trading $10,000 [the purchase price for all the stock] for a $1 billion of cash on the balance sheet by buying all of this company's stock at 100 times earnings. You'd also get all the company's future free cash flows as a bonus.
The market is not this inefficient, of course, where situations like this would occur, but this hypothetical example is very important for two reasons. It shows: 1) valuation multiples can be misleading, and 2) the balance sheet is an absolutely critical component of value, often ignored. How many investors, for example, may be interested in AT&T (T) because it has a low P/E ratio, as described in this article , but are completely overlooking its massive overleveraged net debt position? How many investors think Apple (AAPL) may be too expensive because of its high P/E ratio, but aren't factoring in its huge net cash position and the option value that its robust balance sheet provides?
The stock market is not necessarily full of investors buying low P/E stocks and selling high P/E stocks, but rather it is full of investors that are selling stocks that they believe whose price is above a reasonable estimate of intrinsic value, and investors that are buying stocks that they believe whose price is below a reasonable estimate of intrinsic value. One could sell a high P/E stock because one thinks it is overvalued just because of the P/E, but the stock might not be overvalued at all. That stock could have a huge net cash position on the balance sheet just like the example above, or other valuation dynamics that are fantastic, which aren't captured within this year's or next year's accounting earnings (i.e. the 'E' in the P/E ratio).
Many valuation multiples ignore the balance sheet in this regard, and those valuation multiples that do fail to capture the long-duration nature of future expected financials (e.g. EBITDA five to ten years from now in the EV/EBITDA ratio), which is a critical component of investing. The net cash a company holds on the balance sheet is only one component of the cash-based sources of intrinsic value, however. The other is future enterprise free cash flows. We love companies that have the prospect of the market building in ever-increasing expectations of future free cash flows, and we generally find these names in the areas of big cap tech and large cap growth these days.
Many dividend paying stocks, on the other hand, tend to be weighed down by large net debt positions and future expected dividend liabilities, which impairs capital appreciation potential. As explained in the free dividends fallacy , it seems many readers have a difficult time understanding that the dividend is not independent of the share price, that a company's share price is actually reduced by the amount of the dividend on the ex-dividend date. This dynamic can be explained and supported within the enterprise valuation construct, as net cash is reduced by the amount of the dividend, reducing a company's intrinsic value (and therefore its share price). Let's discuss this further.
We learn a lot from the culture we live in, the education system we promote, and the games we play. Who hasn't played Monopoly, the age-old game that Hasbro ( HAS ) scooped up from Parker Brothers, first distributed in 1935? For more than 80 years now, men and women of all ages have been collecting $50 from the "bank" after pulling one of the more-fortuitous Chance cards. Ingrained in society has become the belief that a dividend is incremental, that something is given to shareholders that otherwise was not there. After all, the Monopoly player now has $50, when prior to pulling the Chance card he or she didn't. But unlike the make-believe Monopoly game, a stock's dividend is nothing like this.
The enterprise valuation framework makes it clear that the dividend is but a symptom of value, not a causal driver behind a company's value, and market observers know that on the stock exchange, the share price of a dividend-paying company is marked downward by the market specialist in the amount of the dividend on the ex-dividend date. A dividend then becomes, in theory, capital appreciation that otherwise would have occurred had the company not paid a dividend at all. The value of a dividend-paying company, instead, rests in the actions the dividend-paying company takes to replenish that income stream such that it is sustainable long into the future.
This figure above illustrates how the dividend is a component of capital appreciation that otherwise would have been achieved had the dividend not been paid. Such a situation applies to both regular and special dividends. A company is worth more because its operations generate more free cash flow, not just because it may or may not pay an increasing dividend. In an extreme case, receiving a dividend payment can be largely described as getting paid with your own money because that dividend you just received had already been reflected in the price of the stock you already owned prior to the dividend payment (as with all assets of the business, shareholders already have a claim on the cash dividend they receive, even before its paid).
That said, many investors may prefer the dividend for cash-flow reasons (and tax implications can impact how investors would like to receive their returns), but in many respects, perhaps the primary utility of the dividend payment, whether a monthly or quarterly one or other, is the structure and timing of the income payment to the investor. The idea that paying a dividend keeps excess capital out of the hands of management, which may be tempted to pursue what could end up being value-destroying endeavors (if it sees its cash coffers swell), may be another reason to like dividends. One might think of this reason as perhaps similar in thinking to how companies load up on debt to provide a layer of discipline on operations such that debt servicing costs can be met.
But could the significance of the dividend be overstated? Shouldn't the focus be primarily on the company's intrinsic value generation, not on what could largely be considered a discretionary dividend policy? Is Berkshire Hathaway ( BRK.A ) ( BRK.B ) any less attractive of an investment idea because it hasn't paid a dividend in 50+ years? Are there other ways for financial advisors to structure income payments to meet their clients' requests without stretching needlessly for "getting paid with their own money (i.e. the dividend)," especially if it leads to overpaying for stock? In this sense, is the tail (the ease of income policy with dividend payments) wagging the dog (the decisions in setting prudent investment policies for retirees)? Management teams should do a better job explaining what a cash dividend is and what it is not. This might save many executive teams from encountering a lot of trouble in trying to pay out more than the business can handle (source: Value Trap: Theory of Universal Valuation , used with permission).
Let's use another real-life example of a more prominent company such as Microsoft (MSFT). Back in 2004, Microsoft announced a special one-time dividend in the amount of $3 per share. It was payable to shareholders of record as of November 17, 2004, so to be eligible for the dividend, one had to buy the stock the week before, at least two trading (business) days before the record date, before the company went ex-dividend after November 12, 2004. Clearly, the chart below shows that Microsoft's shares were adjusted downward by the $3-per share dividend following the ex-dividend date, and while trading subsequent to that event impacted the stock, it is still important to understand this important market function when it comes to the dividend. If Microsoft had not paid this $3 per-share special one-time dividend, it is fair to assume that its share price would not have been adjusted down by the dividend. Perhaps this is easy to understand for many readers; for other readers, it may be helpful to evaluate the chart below to facilitate the understanding.
Don't get me wrong: Dividends are great. They serve a number of purposes for investors, and companies that pay a free-cash-flow backed dividend can be great long-term investments. Visa (V), Apple and Microsoft are just a few of our dividend-paying favorites. We also provide a Dividend Growth Newsletter as well as a High Yield Dividend Newsletter to our members, but a dividend is what it is: capital appreciation that otherwise would have been achieved had the dividend not been paid. Within the enterprise free cash flow construct, the dividend is cash that otherwise would have piled up on the balance sheet instead of being dispersed to shareholders. Looking at how stock prices adjust following large, one-time dividends is perhaps the best way to understand the dividend payment, while studying the enterprise valuation process, or the discounted cash-flow method, helps investors understand why this adjustment occurs.
Now, for the skeptics of whether the share price is adjusted down by the dividend payment on the ex-dividend date, we're not sure what more evidence may be needed to explain this dynamic. Over the period of when a company goes ex-dividend and when it opens the next day, investors would have achieved, or rather retained, that capital appreciation that otherwise had shifted into the dividend payment. Over this short time period, it becomes evident that the dividend is capital appreciation that otherwise would have been achieved had the dividend not been paid. That said, however, market forces are continuously impacting the stock price, both in post-market and pre-market trading, so the change in one day from the pre- ex-dividend date to the post ex-dividend date may not match the dividend precisely, but this is splitting hairs, and shouldn't matter in the context of facilitating this important understanding of the dividend payment.
Now, one might say that this example covers just a short period of time. But let's think logically over longer periods of time. Is it more logical to assume, that for a company that has paid a growing dividend for decades, that had it not paid a growing dividend for decades, that its total return would just be its observed historical capital appreciation return over many decades? Of course not. All that cash the company dispersed as dividends years ago would instead have accrued on the balance sheet bolstering its intrinsic value, and its share price and market capitalization would be significantly higher today had it not paid dividends, resulting in even greater capital appreciation. In this context, it becomes clear that total return is therefore independent of the dividend yield. There is something else driving total return, independent of a company's dividend policy, and that "something" we believe is enterprise valuation and the fair value estimate, derived through the cash-based sources of intrinsic value. Net cash on the balance sheet is a critical component of intrinsic value, a cash-based source augmented over time by future free cash flows.
Understanding how the dividend is tied to the stock price--that it is not independent of it--may help investors better understand what they are trying to do in the stock market, and it may influence how they may seek to achieve their goals. For example, many investors may have income as the primary goal and suggest that capital appreciation is a secondary condition. However, with the understanding that the dividend can be viewed as capital appreciation that otherwise would have been achieved had the dividend not been paid, would investors pursue a different strategy, knowing they can sell off a portion of shares, much like in similar fashion how their capital position in a name is reduced by the amount of the dividend when a company pays a dividend?
In this regard, income and capital appreciation are tied at the hip, and a total return focus becomes much more important, as capital can be sold to meet income requirements. Looking at year-to-date performance so far in 2023 has shown that dividend-paying equities have lagged the market considerably, and those that only focus on the dividend may have overlooked many strong net-cash-rich, free-cash-flow generating equities such as those found in big cap tech and large cap growth. As the image above shows, a myopic focus on dividend income and a lack of understanding of the structural dynamics of the dividend payment may lead investors to significant underperformance, as revealed by performance of master limited partnerships (AMLP) and mortgage REITs (REM) the past decade. Dividend-paying REITs, as shown in the image below, have also struggled heavily in recent years. Risk-free-rates rising to north of 5% have put the backs of many dividend-paying stocks against the wall.
Now to the question we posed in the title of this article: Should Microsoft pay a special one-time dividend (again)? Well, it all depends on a number of dynamics including investor preferences and the like, but from our perspective, we're largely indifferent to whether it delivers a large portion of its net cash position to shareholders as a special one-time dividend, with some important qualifications. First, we understand that the dividend is capital appreciation that otherwise would have been achieved had the dividend not been paid. So, paying a special one-time dividend can be viewed largely as 'six of one, and a half dozen of the other.' This is why many investors may be largely indifferent to special one-time dividends and dividend policies, more generally--assuming of course such dividend policies don't threaten the financial health of the entity (e.g. when it pays out more in dividends than it generates in free cash flow).
However, in many respects, we might actually prefer that Microsoft not pay another special one-time dividend, as it would reduce the net cash position on its balance sheet, a condition that we like a lot. Net cash is not only an add-back to a company's future enterprise free cash flows in calculating intrinsic value (a fair value estimate), but net cash also provides option value to scoop up assets on the cheap during the most troubling times when credit becomes expensive. Right now, Microsoft is looking to close on its deal for Activision (ATVI), but there may be other assets at a different time in the future it can purchase (without having to take on debt). Whatever Microsoft's future capital allocation policy may be, however, the high end of our DCF-derived fair value estimate of Microsoft stands close to $370 per share, and for this, we continue to like shares (we talk even more about why we like Microsoft in this article ).
Hartzmark and Solomon indicate that "the dividend disconnect applies to not only retail investors but also to a number of institutions and mutual funds." They also seem to ponder the best ways to teach investors about the structural dynamics of dividend and the free dividends fallacy, more generally, suggesting that how to do so, however, "remains an open and interesting question." Will articles on Seeking Alpha that graphically walk through how a company's share price is adjusted downward by the amount of the dividend help investors better understand the structural dynamics of dividend payment? We think so--otherwise, we wouldn't have written this one. With that said, what are your thoughts on special one-time dividends? Should Microsoft pay another one? Post your thoughts in the comments section, and don't forget to follow us on Seeking Alpha!
For further details see:
Should Microsoft Pay A Special One-Time Dividend (Again)?