Returning Cash to the Owners:

Dividend Policy
AswathDamodaran

Aswath Damodaran

First Principles

Investinprojectsthatyieldareturngreaterthantheminimumacceptable
hurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthefinancing
mixusedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgeneratedandthe
timingofthesecashflows;theyshouldalsoconsiderbothpositiveandnegative
sideeffectsoftheseprojects.

Chooseafinancingmixthatminimizesthehurdlerateandmatchesthe
assetsbeingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthe
cashtostockholders.
Theformofreturnsdividendsandstockbuybackswilldependuponthe
stockholderscharacteristics.

Objective:MaximizetheValueoftheFirm
Aswath Damodaran

Dividends are sticky

Figure21.6:DividendChanges:19891998

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

Year

Increasingdividends

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Decreasingdividends

Notchangingdividends

Dividends tend to follow Earnings

40
35
30
25

Earnings
Dividends

20
15
10
5
0

Aswath Damodaran

Dividends follow the Life Cycle

$Revenues/
Earnings

Aswath Damodaran

More companies are buying back stock..

$250,000.00

$200,000.00

$150,000.00

$100,000.00

$50,000.00

$1988

1989

1990

1991

1992

1993

Stock Buybacks

Aswath Damodaran

1994

1995

1996

1997

1998

Dividends

Measures of Dividend Policy

DividendPayout:
measuresthepercentageofearningsthatthecompanypaysindividends
=Dividends/Earnings

DividendYield

measuresthereturnthataninvestorcanmakefromdividendsalone
=Dividends/StockPrice

Aswath Damodaran

Dividend Payout Ratios in the United States

1000

900

800

700

600

500

400

300

200

100

0
0%

Aswath Damodaran

010%

1020%

2030%

3040%

4050%

5060%

6070%

7080%

8090%

90100%

>100%

Dividend Yields in the United States

1000

900

800

700

600

500

400

300

200

100

0
0.0%

Aswath Damodaran

00.5%

0.51%

11.5%

1.52%

22.5%

2.53%

33.5%

3.54%

44.5%

4.55%

>5%

Three Schools Of Thought On Dividends

1.If
(a)therearenotaxdisadvantagesassociatedwithdividends
(b)companiescanissuestock,atnocost,toraiseequity,whenever
needed
Dividendsdonotmatter,anddividendpolicydoesnotaffectvalue.

2.Ifdividendshaveataxdisadvantage,

Dividendsarebad,andincreasingdividendswillreducevalue

3.Ifstockholderslikedividends,ordividendsoperateasasignaloffutureprospects,

Dividendsaregood,andincreasingdividendswillincreasevalue

Aswath Damodaran

10

Dividends dont affect value

TheMillerModiglianiHypothesis:Dividendsdonotaffectvalue
Basis:
Ifafirm'sinvestmentpolicy(andhencecashflows)don'tchange,the
valueofthefirmcannotchangewithdividendpolicy.Ifweignore
personaltaxes,investorshavetobeindifferenttoreceivingeither
dividendsorcapitalgains.

UnderlyingAssumptions:
(a)Therearenotaxdifferencesbetweendividendsandcapitalgains.
(b)Ifcompaniespaytoomuchincash,theycanissuenewstock,withno
flotationcostsorsignalingconsequences,toreplacethiscash.
(c)Ifcompaniespaytoolittleindividends,theydonotusetheexcess
cashforbadprojectsoracquisitions.

Aswath Damodaran

11

A Simple Example proving Dividend Irrelevance

LongLast Corporation, an unlevered firm manufacturing furniture, has
operatingincomeaftertaxesof$100million,growingat5%ayear,andthat
its cost of capital is 10%. Further, assume that this firm has reinvestment
needs of $ 50 million, also growing at 5% a year, and that there are 105
million shares outstanding. Finally, assume that this firm pays out residual
cashflowsasdividendseachyear.
FreeCashFlowtotheFirm=EBIT(1taxrate)Reinvestmentneeds
=$100million$50million=$50million
ValueoftheFirm=FreeCashFlowtoFirm(1+g)/(WACCg)
=$50(1.05)/(.10.05)=$1050million
Pricepershare=$1050million/105million=$10.00
Dividendpershare=$50million/105million=$0.476
TotalValueperShare=$10.00+$0.48=$10.476

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12

LongLast doubles dividends

Assumingthatthefirmsinvestmentpolicydoesnotchange,thiswill
meanthatthefirmhastoissue$50millionofequitytomeetits
reinvestmentneeds:
ValueoftheFirm=$50(1.05)/(.10.05)=$1050million
Value of the Firm for existing stockholders after dividend payment = $
1000 million (The remaining $ 50 million belongs to new
stockholders)
Pricepershare=$1000million/105million=$9.523
Dividendspershare=$100million/105millionshares=$0.953
TotalValuePerShare=$9.523+$0.953=$10.476

Aswath Damodaran

13

LongLast eliminates dividends

Inthiscase,thefirmwillaccumulateacashbalanceof$50million.
Thetotalvalueofthefirmcanbeestimatedasfollows:
ValueofFirm=PresentValueofAftertaxOperatingCF+CashBalance
=$50(1.05)/(.10.05)+$50million=$1100million
Valuepershare=$1100million/105millionshares=$10.476

Aswath Damodaran

14

The Tax Response: Dividends are taxed more

than capital gains

Basis:
Dividendsaretaxedmoreheavilythancapitalgains.Astockholderwill
thereforeprefertoreceivecapitalgainsoverdividends.

Evidence:
Examiningexdividenddatesshouldprovideuswithsomeevidenceon
whetherdividendsareperfectsubstitutesforcapitalgains.

Aswath Damodaran

15

Price Behavior on Ex-Dividend Date

LetPb=Pricebeforethestockgoesexdividend
Pa=Priceafterthestockgoesexdividend
D=Dividendsdeclaredonstock
to,tcg=Taxespaidonordinaryincomeandcapitalgainsrespectively

$Pb
$Pa
______________|_______ExD
ividendDay_ ______________|

Aswath Damodaran

16

Cashflows from Selling around Ex-Dividend

Day
Thecashflowsfromsellingbeforethenare
Pb(PbP)tcg
Thecashflowsfromsellingaftertheexdividenddayare
Pa(PaP)tcg+D(1to)
Sincetheaverageinvestorshouldbeindifferentbetweensellingbefore
theexdividenddayandsellingaftertheexdividendday
Pb(PbP)tcg=Pa(PaP)tcg+D(1to)
Movingthevariablesaround,wearriveatthefollowing:

Aswath Damodaran

17

Price Change, Dividends and Tax Rates

P b P a
(1 t o)
=
D
(1 t cg )

If

Aswath Damodaran

PbPa=D
PbPa<D
PbPa>D

then
then
then

to=tcg
to>tcg
to<tcg

18

The Evidence on Ex-Dividend Day Behavior

Ordi naryI nco me

Capit al Gai ns

( Pb Pa)/ D

Bef ore 1981

70 %

28 %

0. 78( 1966 69)

1981 85

50 %

20 %

0. 85

1986 1990

28 %

28 %

0. 90

1991 1993

33 %

28 %

0. 92

1994..

39. 6 %

28 %

Aswath Damodaran

19

Dividend Arbitrage

Assumethatyouareataxexemptinvestor,andthatyouknowthatthe
pricedropontheexdividenddayisonly90%ofthedividend.How
wouldyouexploitthisdifferential?
Investinthestockforthelongterm
Sellshortthedaybeforetheexdividendday,buyontheexdividend
day
Buyjustbeforetheexdividendday,andsellafter.
______________________________________________

Aswath Damodaran

20

Example of dividend capture strategy with tax

factors

XYZcompanyissellingfor$50atcloseoftradingMay3.OnMay4,
XYZgoesexdividend;thedividendamountis$1.Thepricedrop
(frompastexaminationofthedata)isonly90%ofthedividend
amount.
ThetransactionsneededbyataxexemptU.S.pensionfundforthe
arbitrageareasfollows:
1.Buy1millionsharesofXYZstockcumdividendat$50/share.
2.Waittillstockgoesexdividend;Sellstockfor$49.10/share(501*
0.90)
3.Collectdividendonstock.

Netprofit=50million+49.10million+1million=$0.10million

Aswath Damodaran

21

Bad Reasons for Paying Dividends

Thebirdinthehandfallacy:Dividendsarebetterthancapitalgains
becausedividendsarecertainandcapitalgainsarenot.
TheExcessCashArgument:Theexcesscashthatafirmhasinany
periodshouldbepaidoutasdividendsinthatperiod.

Aswath Damodaran

22

The bird in the hand fallacy

Argument:Dividendsnowaremorecertainthancapitalgainslater.
Hencedividendsaremorevaluablethancapitalgains.
Counter:Theappropriatecomparisonshouldbebetweendividends
todayandpriceappreciationtoday.(Thestockpricedropsontheex
dividendday.)

Aswath Damodaran

23

The excess cash hypothesis

Argument:Thefirmhasexcesscashonitshandsthisyear,no
investmentprojectsthisyearandwantstogivethemoneybackto
stockholders.
Counter:Sowhynotjustrepurchasestock?Ifthisisaonetime
phenomenon,thefirmhastoconsiderfuturefinancingneeds.
Considerthecostofissuingnewstock:

Aswath Damodaran

24

The Cost of Raising Funds

Issuingnewequityismuchmoreexpensivethanraisingnewdebtfor
companiesthatarealreadypubliclytraded,intermsoftransactions
costsandinvestmentbankingfees
Raisingsmallamountsismuchmoreexpensivethanraisinglarge
amounts,forbothequityanddebt.Makingasmallequityissue(say$
25$50millionmightbeprohibitivelyexpensive)

Aswath Damodaran

25

Issuance Costs

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
Under$1mil

$1.01.9mil

$2.04.9mil

CostofIssuingbonds

Aswath Damodaran

$5.0$9.9mil

$1019.9mil

$2049.9mil

$50milandover

CostofIssuingCommonStock

26

Some companies pay dividends and fund them

by issuing stock.

7.0%

60.00%

6.0%

50.00%

5.0%
40.00%
NewIssueYld
NewIssues

4.0%
30.00%
3.0%
20.00%
2.0%
10.00%

1.0%

0.0%

0.00%
Nodividends

Aswath Damodaran

<1%

12%

24.5%

>4.5%

27

Potentially Good Reasons for Paying Dividends

TheClienteleArgument:Therearestockholderswholikedividends,
eitherbecausetheyvaluetheregularcashpaymentsordonotfacea
taxdisadvantage.Ifthesearethestockholdersinyourfirm,paying
moreindividendswillincreasevalue.
DividendsasSignals:Dividendincreasesmayoperateasapositive
signaltofinancialmarketsandthusincreasestockprices.
WealthTransfer:Byreturningmorecashtostockholders,there
mightbeatransferofwealthfromthebondholderstothe
stockholders.

Aswath Damodaran

28

Some stockholders like dividends: A Case

Study

Aswath Damodaran

29

Evidence from Canadian Firms

Company

PremiumforCashdividendover
StockDividendShares

ConsolidatedBathurst

19.30%

Donfasco

13.30%

DomePetroleum

0.30%

ImperialOil

12.10%

NewfoundlandLight&Power

1.80%

RoyalTrustco

17.30%

Stelco

2.70%

TransAlta

1.10%
Average

Aswath Damodaran

7.54%

30

A clientele based explanation

Basis:Investorsmayformclientelesbasedupontheirtaxbrackets.
Investorsinhightaxbracketsmayinvestinstockswhichdonotpay
dividendsandthoseinlowtaxbracketsmayinvestindividendpaying
stocks.
Evidence:Astudyof914investors'portfolioswascarriedouttoseeif
theirportfoliopositionswereaffectedbytheirtaxbrackets.Thestudy
foundthat
(a)Olderinvestorsweremorelikelytoholdhighdividendstocksand
(b)Poorerinvestorstendedtoholdhighdividendstocks

Aswath Damodaran

31

Results from Regression: Clientele Effect

DividendYieldt=a+bt+cAget+dIncomet+eDifferentialTaxRatet+t
Variable

Coefficient

Implies

Constant

4.22%

BetaCoefficient

2.145

Higherbetastockspaylowerdividends.

Age/100

3.131

Firmswitholderinvestorspayhigher
dividends.

Income/1000

3.726

Firmswithwealthierinvestorspaylower
dividends.

DifferentialTaxRate

2.849

Ifordinaryincomeistaxedatahigherrate
thancapitalgains,thefirmpaysless
dividends.

Aswath Damodaran

32

Dividend Policy and Clientele

Assumethatyourunaphonecompany,andthatyouhavehistorically
paidlargedividends.Youarenowplanningtoenterthe
telecommunicationsandmediamarkets.Whichofthefollowingpaths
areyoumostlikelytofollow?
Courageouslyannouncetoyourstockholdersthatyouplantocut
dividendsandinvestinthenewmarkets.
Continuetopaythedividendsthatyouusedto,anddeferinvestment
inthenewmarkets.
Continuetopaythedividendsthatyouusedto,maketheinvestments
inthenewmarkets,andissuenewstocktocovertheshortfall
Other

Aswath Damodaran

33

The Signaling Hypothesis

Aswath Damodaran

34

The Wealth Transfer Hypothesis

EXCESS RETURNS ON STRAIGHT BONDS AROUND DIVIDEND CHANGES

0.5
0
t:- -12 -9
-0.5 15

-6

-3

CAR

12

15
CAR (Div Up)
CAR (Div down)

-1
-1.5
-2
Day (0: Announcement date)

Aswath Damodaran

35

Questions to Ask in Dividend Policy Analysis

Howmuchcouldthecompanyhavepaidoutduringtheperiodunder
question?
Howmuchdidthethecompanyactuallypayoutduringtheperiodin
question?
HowmuchdoItrustthemanagementofthiscompanywithexcess
cash?
Howwelldidtheymakeinvestmentsduringtheperiodinquestion?
Howwellhasmystockperformedduringtheperiodinquestion?

Aswath Damodaran

36

A Measure of How Much a Company Could

have Afforded to Pay out: FCFE

TheFreeCashflowtoEquity(FCFE)isameasureofhowmuchcashis
leftinthebusinessafternonequityclaimholders(debtandpreferred
stock)havebeenpaid,andafteranyreinvestmentneededtosustainthe
firmsassetsandfuturegrowth.
NetIncome
+Depreciation&Amortization
=CashflowsfromOperationstoEquityInvestors
PreferredDividends
CapitalExpenditures
WorkingCapitalNeeds
PrincipalRepayments
+ProceedsfromNewDebtIssues
=FreeCashflowtoEquity

Aswath Damodaran

37

Estimating FCFE: The Home Depot - 1989-98

Year

NetIncome

1
2
3
4
5
6
7
8
9
10
Average

$111.95
$163.43
$249.15
$362.86
$457.40
$604.50
$731.52
$937.74
$1,160.00
$1,615.00
$639.36

Aswath Damodaran

Depreciation CapitalSpending ChangeinNon

cashWorking
Capital
$21.12
$190.24
$6.20
$34.36
$398.11
$10.41
$52.28
$431.66
$47.14
$69.54
$432.51
$93.08
$89.84
$864.16
$153.19
$129.61
$1,100.65
$205.29
$181.21
$1,278.10
$247.38
$232.34
$1,194.42
$124.25
$283.00
$1,481.00
$391.00
$373.00
$2,059.00
$131.00
$146.63
$942.99
$140.89

NetDebtIssued

FCFE

$181.88
$228.43
$1.94
$802.87
$2.01
$97.83
$497.18
$470.24
$25.00
$238.00
$248.75

$118.51
$17.70
($179.31)
$709.68
($472.12)
($474.00)
($115.57)
$321.65
($454.00)
$36.00
($49.15)

38

Estimating FCFE when Leverage is Stable

NetIncome
(1)(CapitalExpendituresDepreciation)
(1)WorkingCapitalNeeds
=FreeCashflowtoEquity
=Debt/CapitalRatio
Forthisfirm,
Proceedsfromnewdebtissues=PrincipalRepayments+(Capital
ExpendituresDepreciation+WorkingCapitalNeeds)

Aswath Damodaran

39

Re-estimating FCFE: The Home Depot

Year
1
2
3
4
5
6
7
8
9
10
Average

NetIncome
$111.95
$163.43
$249.15
$362.86
$457.40
$604.50
$731.52
$937.74
$1,160.00
$1,615.00
$639.36

NetCapitalExpenditures(1DR) ChangeinNonCashWC(1DR)
FCFE
$124.24
$4.55
($16.84)
$267.21
$7.65
($111.43)
$278.69
$34.63
($64.17)
$266.64
$68.38
$27.85
$568.81
$112.53
($223.95)
$713.32
$150.81
($259.63)
$805.77
$181.72
($255.98)
$706.74
$91.27
$139.72
$880.05
$287.23
($7.28)
$1,238.53
$96.23
$280.24
$585.00
$103.50
($49.15)

=Averagedebtratioduringtheperiod=26.54%

Aswath Damodaran

40

The Home Depot: Cash Returned to

Stockholders

Year
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998

Aswath Damodaran

Dividends (in $) Equity Repurchases (in $) Cash to Equity

$8.39
$0.00
$8.39
$12.84
$0.00
$12.84
$22.45
$0.00
$22.45
$35.82
$0.00
$35.82
$50.34
$0.00
$50.34
$67.79
$0.00
$67.79
$89.75
$0.00
$89.75
$110.21
$0.00
$110.21
$139.00
$0.00
$139.00
$168.00
$0.00
$168.00

41

Dividends with Negative FCFE

Duringtheperiod198998,theHomeDepothasconsistentlyhad
negativefreecashflowstoequity.Ithas,however,managedtopay
dividendsineachoftheseyears.
Howdoesacompanywithnegativefreecashflowstoequitypay
dividends(orbuybackstock)?

Whymightitdoso?

Aswath Damodaran

42

Estimating FCFE: Boeing - 1989-98

Year
1
2
3
4
5
6
7
8
9
10
Average

NetIncome NetCapitalExpenditures(1DR) ChangeinNonCashWC(1DR)

$973.00
$423.80
$333.27
$1,385.00
$523.55
$113.59
$1,567.00
$590.44
($55.35)
$552.00
$691.34
($555.26)
$1,244.00
$209.88
$268.12
$856.00
($200.08)
$6.34
$393.00
($232.95)
($340.77)
$1,818.00
($155.68)
($21.91)
($178.00)
$516.63
($650.98)
$1,120.00
$754.77
$107.25
$973.00
$312.17
($79.57)

FCFE
$215.93
$747.86
$1,031.92
$415.92
$766.00
$1,049.74
$966.72
$1,995.59
($43.65)
$257.98
$740.40

=Averagedebtratioduringtheperiod=42.34%

Aswath Damodaran

43

Boeing: Cash Returned to Stockholders

Year
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998

Aswath Damodaran

Dividends (in $) Equity Repurchases (in $) Cash to Equity

$269.00
$2.00
$271.00
$328.00
$156.00
$484.00
$343.00
$127.00
$470.00
$340.00
$109.00
$449.00
$340.00
$0.00
$340.00
$340.00
$0.00
$340.00
$342.00
$0.00
$342.00
$480.00
$718.00
$1,198.00
$557.00
$141.00
$698.00
$564.00
$1,397.00
$1,961.00

44

Cash Returned versus FCFE

Onaverage,Boeinghasreturned$655millionayearoverthis10
yearperiod.Onaverage,Boeinghashadfreecashflowstoequityof$
740millioneachyearoverthesameperiod.
Wheredoesthedifference($740$655)accumulate?

WhymightfirmspayoutlessthantheyhaveavailableasFCFE?

Aswath Damodaran

45

Dividends versus FCFE: U.S.

Figure 22.2: Cash Returned as Percent of FCFE

1200

1000

800

600

400

200

0%

Aswath Damodaran

0-10%

10-20%

20-30%

30-40%

40-50%

50-60%

60-70%

70-80%

80-90%

90-100%

>100%

46

The Consequences of Failing to pay FCFE

$3,000

$9,000
$8,000

$2,500

$7,000
$2,000
$6,000
$1,500

$5,000

$1,000

$4,000

$3,000
$500
$2,000
$0
1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

($500)

$0

= Free CF to Equity

Aswath Damodaran

$1,000

= Cash to Stockholders

Cumulated Cash

47

 Application Test: Estimating your firms FCFE

InGeneral,
NetIncome
+Depreciation&Amortization
CapitalExpenditures
ChangeinNonCashWorkingCapital
PreferredDividend
PrincipalRepaid
+NewDebtIssued
+ChangeinSTBorrowing
=FCFE

Compareto
Dividends(Common)
DecreaseinCapitalStock
+IncreaseinCapitalStock

Aswath Damodaran

Ifcashflowstatementused
NetIncome
+Depreciation&Amortization
+CapitalExpenditures
+ChangesinNoncashWC
+PreferredDividend
+IncreaseinLTBorrowing
+DecreaseinLTBorrowing
=FCFE

CommonDividend

+StockBuybacks

48

A Practical Framework for Analyzing Dividend

Policy
How much did the firm pay out? How much could it have afforded to pay out?
What it could have paid out
What it actually paid out
Net Income
Dividends
- (Cap Ex - Deprn) (1-DR)
+ Equity Repurchase
- Chg Working Capital (1-DR)
= FCFE
Firm pays out too little
FCFE > Dividends

Firm pays out too much

FCFE < Dividends

Do you trust managers in the company with

your cash?
Look at past project choice:
Compare ROE to Cost of Equity
ROC to WACC

Aswath Damodaran

What investment opportunities does the

firm have?
Look at past project choice:
Compare ROE to Cost of Equity
ROC to WACC

Firm has history of

good project choice
and good projects in
the future

Firm has history

of poor project
choice

Firm has good

projects

Give managers the

flexibility to keep
cash and set
dividends

Force managers to
justify holding cash
or return cash to
stockholders

Firm should
cut dividends
and reinvest
more

Firm has poor

projects

Firm should deal

with its investment
problem first and
then cut dividends

49

Evaluating the Quality of Investments

MeasuringProjectQuality
AccountingReturndifferentials,wherewecomparetheaccountingreturn
onequitytothecostofequityandtheaccountingreturnoncapitaltothe
costofcapital.
Economic value Added, which measures the excess return earned on
capitalinvestedinexistinginvestments,andcanbecomputedeitheronan
equityorcapitalbasis.

StockPricePerformance
Excessreturns,relativetothemarket(giventheriskinessofastock)
In an efficient market, this can be considered to be an evaluation of
whetherafirmearnareturnonitsinvestmentsthatweregreaterthanor
lessthanthoseexpectedbythemarket.

Aswath Damodaran

50

The Four Possible Combinations

Afirmmayhavegoodprojectsandmaybepayingoutmorethanitsfreecash
flowtoequity:Thefirmislosingvalueintwoways.
Itiscreatingacashshortfallthathastobemetbyissuingmoresecurities.
Overpayingmaycreatecapitalrationingconstraints;asaresult,thefirmmayreject
goodprojectsitotherwisewouldhavetaken.

Afirmmayhavegoodprojectsandmaybepayingoutlessthanitsfreecash
flowtoequityasadividend.Thisfirmwillaccumulatecash,butstockholders
areunlikelytoinsistthatitbepaidoutbecauseofthefirmstrackrecord.
Afirmmayhavepoorprojectsandmaybepayingoutlessthanitsfreecash
flow to equity as a dividend. This firm will also accumulate cash, but find
itselfunderpressurefromstockholderstodistributethecash.
Afirmmayhavepoorprojectsandmaybepayingoutmorethanitsfreecash
flow to equity as a dividend. This firm has an investment problem and a
dividendproblem.

Aswath Damodaran

51

A Dividend Matrix

Boeing

Aswath Damodaran

52

Boeing: Summary Statistics on Cash Returned

versus FCFE

Year

Dividends

NetIncome

PayoutRatio

1
2
3
4
5
6
7
8
9
10
Avg

$269.00
$328.00
$343.00
$340.00
$340.00
$340.00
$342.00
$480.00
$557.00
$564.00
$390.30

$973.00
$1,385.00
$1,567.00
$552.00
$1,244.00
$856.00
$393.00
$1,818.00
($178.00)
$1,120.00
$973.00

27.6%
23.7%
21.9%
61.6%
27.3%
39.7%
87.0%
26.4%
312.9%
50.4%
40.1%

Aswath Damodaran

Dividends+Stock
Buybacks
$271.00
$484.00
$470.00
$449.00
$340.00
$340.00
$342.00
$1,198.00
$698.00
$1,961.00
$655.30

FCFE
$215.93
$747.86
$1,031.92
$415.92
$766.00
$1,049.74
$966.72
$1,995.59
($43.65)
$257.98
$740.40

Cashto
Stockholders/FCFE
125.51%
64.72%
45.55%
107.95%
44.39%
32.39%
35.38%
60.03%
1598.99%
760.12%
88.51%

53

Boeing: Measuring Investment Quality

80.00%

60.00%

40.00%

20.00%

0.00%
1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

Average

-20.00%

-40.00%

ROE

Aswath Damodaran

Return on Stock

Cost of Equity

54

Can you trust Boeings management?

IfyouwereaBoeingstockholder,wouldyoubecomfortablewith
Boeingsdividendpolicy?
Yes
No

Aswath Damodaran

55

Aracruz: Dividends and FCFE: 1994-1996

1994
NetIncome
BR248.21
(Cap.ExpDepr)*(1DR) BR174.76
WorkingCapital*(1DR) (BR47.74)
=FreeCFtoEquity
BR121.19
Dividends
+EquityRepurchases
=CashtoStockholders

Aswath Damodaran

1995
BR326.42
BR197.20
BR15.67
BR113.55

BR80.40 BR113.00
BR0.00 BR0.00
BR80.40 BR113.00

1996
BR47.00
BR14.96
(BR23.80)
BR55.84
BR27.00
BR0.00
BR27.00

56

Aracruz: Investment Record

1994
ProjectPerformanceMeasures
ROE
19.98%
Requiredrateofreturn
3.32%
Difference
16.66%
StockPerformanceMeasure
Returnsonstock
50.82%
Requiredrateofreturn
3.32%
Difference
47.50%

Aswath Damodaran

1995

1996

16.78%
28.03%
11.25%

2.06%
17.78%
15.72%

0.28%
28.03%
28.31%

8.65%
17.78%
9.13%

57

Aracruz: Its your call..

AssumethatyouarealargestockholderinAracruz.Theyhavea
historyofpayinglessindividendsthantheyhaveavailableinFCFE
andhaveaccumulatedacashbalanceofroughly1billionBR(25%of
thevalueofthefirm).WouldyoutrustthemanagersatAracruzwith
yourcash?
Yes
No

Aswath Damodaran

58

Mandated Dividend Payouts

Therearemanycountrieswherecompaniesaremandatedtopayouta
certainportionoftheirearningsasdividends.Givenourdiscussionof
FCFE,whattypesofcompanieswillbehurtthemostbytheselaws?
Largecompaniesmakinghugeprofits
Smallcompanieslosingmoney
Highgrowthcompaniesthatarelosingmoney
Highgrowthcompaniesthataremakingmoney

Aswath Damodaran

59

BP: Dividends- 1983-92

1
NetIncome

10

$712.00

$947.00

$1,256.00

$1,626.00 $2,309.00 $1,098.00

$2,076.00

(Cap.ExpDepr)*(1DR) $1,499.00

$1,281.00 $1,737.50 $1,600.00

$580.00

WorkingCapital*(1DR)

$369.50

($286.50)

$678.50

=FreeCFtoEquity

($612.50)

$631.50

($107.00) ($584.00) $3,764.00

$1,940.50 $1,022.00

Dividends

$831.00

$949.00

$1,079.00 $1,314.00

$1,391.00

$1,961.00 $1,746.00 $1,895.00 $2,112.00 $1,685.00

$831.00

$949.00

$1,079.00 $1,314.00

$1,391.00

$1,961.00 $1,746.00 $1,895.00 $2,112.00 $1,685.00

66.16%

58.36%

$82.00

$2,140.00 $2,542.00 $2,946.00

$1,184.00 $1,090.50 $1,975.50 $1,545.50 $1,100.00

($2,268.00) ($984.50)

$429.50

$1,047.50
($77.00)

($305.00) ($415.00)
($528.50)

$262.00

+EquityRepurchases
=CashtoStockholders
DividendRatios
PayoutRatio
CashPaidas%ofFCFE

135.67%

46.73%

119.67%

67.00%

91.64%

68.69%

64.32%

296.63%

177.93%

150.28% 1008.41% 225.00%

36.96%

101.06%

170.84% 2461.04% 399.62%

643.13%

PerformanceRatios
1.AccountingMeasure
ROE

9.58%

12.14%

19.82%

9.25%

12.43%

15.60%

21.47%

19.93%

4.27%

7.66%

Requiredrateofreturn

19.77%

6.99%

27.27%

16.01%

5.28%

14.72%

26.87%

0.97%

25.86%

7.12%

Difference

10.18%

5.16%

7.45%

6.76%

7.15%

0.88%

5.39%

20.90%

21.59%

0.54%

Aswath Damodaran

60

BP: Summary of Dividend Policy

Summaryofcalculations
Average

StandardDeviation

$571.10

$1,382.29

$3,764.00

($612.50)

Dividends

$1,496.30

$448.77

$2,112.00

$831.00

Dividends+Repurchases

$1,496.30

$448.77

$2,112.00

$831.00

11.49%

20.90%

21.59%

FreeCFtoEquity

DividendPayoutRatio

84.77%

CashPaidas%ofFCFE

262.00%

ROERequiredreturn

Aswath Damodaran

1.67%

Maximum Minimum

61

BP: Just Desserts!

Aswath Damodaran

62

The Home Depot: Summary of Cash Returned

and FCFE
Year Dividends
1
2
3
4
5
6
7
8
9
10

Aswath Damodaran

Earnings

$8.39
$111.95
$12.84
$163.43
$22.45
$249.15
$35.82
$362.86
$50.34
$457.40
$67.79
$604.50
$89.75
$731.52
$110.21
$937.74
$139.00
$1,160.00
$168.00
$1,615.00
$70.46 $639.36

PayoutRatio
7.49%
7.86%
9.01%
9.87%
11.01%
11.21%
12.27%
11.75%
11.98%
10.40%
11.02%

Dividends+Stock
Buybacks
$8.39
$12.84
$22.45
$35.82
$50.34
$67.79
$89.75
$110.21
$139.00
$168.00
$70.46

FCFE
$118.51
$17.70
($179.31)
$709.68
($472.12)
($474.00)
($115.57)
$321.65
($454.00)
$36.00
($49.15)

Cashto
Stockholders/FCFE
7.08%
72.54%
12.52%
5.05%
10.66%
14.30%
77.66%
34.26%
30.62%
466.67%
143.37%

63

Evaluating Project Quality at The Home Depot

200.00%

150.00%

100.00%

50.00%

0.00%
1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

Average

-50.00%

ROE

Aswath Damodaran

Return on Stock

Cost of Equity

64

Growth Firms and Dividends

Highgrowthfirmsaresometimesadvisedtoinitiatedividendsbecause
itsincreasesthepotentialstockholderbaseforthecompany(since
therearesomeinvestorslikepensionfundsthatcannotbuystocks
thatdonotpaydividends)and,byextension,thestockprice.Doyou
agreewiththisargument?
Yes
No
Why?

Aswath Damodaran

65

The Home Depot: Looking Forward

NetIncome
(CapExDeprec'n)(1DR)
ChangeinWorkingCapital(1DR)
FCFE
ExpectedDividends
Cashavailableforstockbuybacks

Aswath Damodaran

1999
$1,857
$1,484
$193
$180
$193
($13)

2000
$2,136
$1,632
$213
$291
$222
$69

2001
$2,456
$1,795
$234
$427
$256
$171

2001
$2,825
$1,975
$257
$592
$294
$299

2002
$3,248
$2,172
$283
$793
$338
$455

66

 Application Test: Assessing your firms

dividend policy

CompareyourfirmsdividendstoitsFCFE,lookingatthelast5years
ofinformation.

Baseduponyourearlieranalysisofyourfirmsprojectchoices,would
youencouragethefirmtoreturnmorecashorlesscashtoitsowners?

Ifyouwouldencourageittoreturnmorecash,whatformshouldit
take(dividendsversusstockbuybacks)?

Aswath Damodaran

67

Other Actions that affect Stock Prices

Inthecaseofdividendsandstockbuybacks,firmschangethevalueofthe
assets(bypayingoutcash)andthenumberofshares(inthecaseof
buybacks).
Thereareotheractionsthatfirmscantaketochangethevalueoftheir
stockholdersequity.
Divestitures:Theycansellassetstoanotherfirmthatcanutilizethemmore
efficiently,andclaimaportionofthevalue.
Spinoffs:Inaspinoff,adivisionofafirmismadeanindependententity.
Theparentcompanyhastogiveupcontrolofthefirm.
Equitycarveouts:InanECO,thedivisionismadeasemiindependententity.
Theparentcompanyretainsacontrollinginterestinthefirm.
TrackingStock:Whentrackingstockareissuedagainstadivision,theparent
companyretainscompletecontrolofthedivision.Itdoesnothaveitsown
boardofdirectors.

Aswath Damodaran

68

Differences in these actions

Asset
Control
Parent
Taxed
No
Bondholders
ECO
Spin
Divestitures
Tracking
ECOs
cash
Taxes
offs
completely
on
companhy
fully
for
stock
capital
lost
negatively
gains
covenrted into cash
transaction
preserves
affected
unaffected
stock
control

Aswath Damodaran

69