Dividends Not So Discounted

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GlobalEquity-Linked: Delta One 30 April 2010
Market Stephen Cohen +44 207 1036073 Vincent Li +852 2252 2494
Neil Sheppard +81 3 3213 9699
Commentary
Eamonn Long +44 207 1038586
Dividends not so discounted

In 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 value
of future dividend flows. An adaption of this point would be that the value of an equity should be at least the
risk adjusted present value of future dividend flows and at most the risk adjusted present value of future
earnings. This is to allow for the distribution of investors who are on one end more interested in receiving
dividends to the other end those investors who are interested in controlling the earnings. A more detailed
account 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 of
alignment; 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 not
necessarily quality) of money invested in the market, the conclusion is that it is probable that it is the dividend
market 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 consider
an 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
5000 8000
Implied Spot Close to max misalignment
4500
Spot 7000
4000
6000
3500
3000 5000
2500 4000
Little margin for error Implied Spot
2000
3000 Spot
1500
1000 2000
2005 2006 2007 2008 2009 2005 2006 2007 2008 2009
Source: Bloomberg, Global Equity-Linked Source: Bloomberg, Global Equity-Linked
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.
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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, the
spot should not be below the present value of the dividends.
Ratio of discounted dividends to spot for both the UKX and SX5E. In blue is
the SX5E ratio less the historical maximum distance between the UKX and
 Misalignment
SX5E ratios. For the purposes of calculating maximum distance, data around As the graph on the left
the time of the Lehman bankruptcy is excluded owing to the extreme market demonstrates, the curves
distress are out of alignment. Insofar
Currently close to as the dividend curves are
1.3 UKX SX5E maximum misalignment concerned, there are two
1.2 main possibilities: (i) the
1.1 UKX dividend curve is too
low relative to the SX5E
1 curve; (ii) the SX5E dividend
0.9 curve is too steep relative to
0.8 the UKX dividend curve. It is
possible to argue that both
0.7 are correct. However, it is
0.6 argued below in the payout
0.5 ratio section that that it is
the UKX dividend curve
2005 2006 2007 2008 2009
which is too low.
Source: Nomura Equity-Linked, Bloomberg
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 liquidity
on 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 be
the 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 is
because of the “pull to realised” effect. For example, approximately 75% of the dividends referred to in the Dec
11 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 the
index (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 the
2010 through 2012 dividend futures. The average realised payout ratio on the UKX has been close to 20
percentage points higher than that on the SX5E, generally owing to the greater preference of UK investors for
dividends. Please see the graphs below.
 If the analyst earnings are correct and the 2012 payout ratio were the historical average, this would mean a
70% upside for the UKX while a 17% upside for the SX5E from the current levels, i.e. the 2012 dividend swap
on 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 earnings
estimates are significantly inaccurate. Such an argument could apply on absolute basis, but it seems difficult to
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argue this on a relative basis between the UKX and the SX5E. There is some precedent for an
outperformance of this size; between 2004 and 2007, dividends on the SX5E outperformed dividends on the
UKX by 35%.
The projected payout ratio on the UKX (dividend swap While the project payout ratio on the SX5E, which is in
divided by the earnings estimate for the index) are line with that of the UKX, it is also in line with the
significantly lower than the historical average ... historical average
250%
UKX Index Payout SX5E Index Payout ratio
ratio Projected Projected
140% Hist Average
200% Historical Average
120%
150% 100%
80%
100%
60%
40%
50%
20%
0% 0%
2000 2003 2006 2009 2012 2001 2004 2007 2010
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 the
index. For example, the 2012 implied yield on the SX5E is the 2012 implied dividends (eg from the dividend
futures) divided by the current spot price of the index.
Rolling 5 year yield on the UKX versus the 5 year forward

Rolling 5 year yield on the SX5E versus the 5 year forward
rate on the pound. The two asset returns appear to be in
rate on the Euro. There appears to be a discrepancy.
line.
5.5% 5.0%
6.5% 6.0%
6.0% 5.5% 5.0% 4.5%

5.0%
5.5%
4.5% 4.0%
4.5%
5.0%
4.0% 4.0% 3.5%
4.5%
3.5%
4.0%
3.5% 3.0%
3.0% Forward Rate
Forward Rate
3.5% 2.5% 3.0% 5 Year Yld (RHS) 2.5%
5 Year Yld (RHS)
3.0% 2.0%
2.5% 2.0%
Jun 06 Mar 07 Dec 07 Sep 08 Jun 09 Mar 10
Jun 06 Mar 07 Dec 07 Sep 08 Jun 09 Mar 10
Source: Global Equity-Linked Source: Global Equity-Linked
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 Implied dividend yields are a useful measure of comparing the implied returns on assets. The idea is that, in
some 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 year
dividend yield on the SX5E versus the 5 year forward rate on the Euro as well as the rolling 5 year dividend
yield on the UKX versus the 5 year forward rate on the Pound. The graphs seem to indicate that the yield on
the 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; a
complete reversal of the situation one year ago following the post-Lehman asset liquidation. However, the
UKX 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-dated
SX5E 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 the
individual companies. Typically the estimates are collated out to three years to estimate the yearly dividends
on the index
 Implicitly, it relies on the notion that, while analysts may be biased on individual companies, on an aggregated
basis, the individual biases should cancel out. However, this assumption would seem tenuous in the face of an
unstable macro environment, or if a few large companies dominate the dividend payment on an index. A
usually smaller effect is the index rebalancing over time.
Analyst based bottom up shows a 23% upside to the Whereas the bottom up shows a mere 14% upside to
SX5E 2012 ask... the UKX 2012 ask
145
250 Bottom Up
140 Bottom UP
135
Offer
Offer
230
130
125
120
210
115
110 190
105
100 170
2009 2010 2011 2012 2009 2010 2011 2012
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 the
2012 SX5E dividends.
 Drilling down further, it looks as though approximately 60% of the forecast increase between 2012 and 2010 of
the dividends is expected to come from financials and telecoms. Given the high yields of telecoms (around
7%), the current regulatory environment surrounding banks, as well as potential problems with sovereign Euro
debt, 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, stands
to benefit more from a global recovery as well as macroeconomic trends favouring basic resources and energy
stocks.
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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 were
trading around 55. It is clear then that the analysts were – with hindsight – significantly more accurate than the
market prices. This might be viewed as supporting those who believe that the bottom up approach is not
without 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 2011
SX5E dividend increases. Motivated by this, it seems to be worthwhile investigating further the 2012 SX5E
bottom up of analyst dividend estimates which is predicting a yield of 4.7% on the current SX5E price (as
compared to a forward rate of around 2%).
Forecast dividend point increases between 2010 and 2012 as Forecast dividend point increases between 2010 and 2012
percentage of the 2010 SX5E implied dividend level plotted as percentage of the 2010 UKX implied dividend level
versus yield. It might be surprising that an increase of 3.2 plotted versus yield. The UKX does not seem to have the
dividend points is expected from stocks yielding over 7% same high yielding outliers
4.5% 4.5%
4.0% 4.0%
Significant
3.5% increases forecast 3.5%
from already high
3.0% yielding stocks 3.0%
2.5% 2.5%
2.0% 2.0%
1.5% 1.5%
1.0% 1.0%
0.5% 0.5%
0.0% 0.0%
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 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 yielding
stocks and calibrate this versus the UKX dividend forecasts. For the purposes of this comparison, bank
dividends are excluded because of the political complications mentioned above. For the record, the latest
Markit based bottom up shows a forecast increase of 7.7 index points of dividends coming from the bank
sector on the SX5E between 2010 and 2012. Curiously, an increase of 7.7 index points in dividends is also
forecast 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 be
discounted 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 telecoms
sector (yielding 7% plus) on the SX5E seem to be a little difficult to justify. Indeed, if the telecoms can fund at the
risk free rate + 100 bps or lower in the debt markets, it would seem remiss of management to keep paying risk free
rate + 350 bps or more in the equity markets. In other words, instead of paying all of the dividends in cash, if these
shares do not rally, SX5E telecoms management would be appear to be better advised buying back the shares
instead 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 of
all future dividends and the risk-adjusted present value of all future earnings; i.e. between the price that a
passive investor would pay to own all future dividends and the price that an investor would pay to control and
use all future earnings of the underlying.
 An objection to this approach would be that it accounts neither for the intervention of speculators nor for the
intervention of investors behaving irrationally. On the other hand, the disproportionate presence of either such
interventions 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 know
that market’s expectation of the future dividends as well as the discount rate that the market would apply to
assets with that level of risk. Fortunately, the existence of the dividend swap/futures market means that it isn’t
necessary to know either as the levels are already risk-adjusted (though not adjusted to the risk-free present
value) by the market in which they are trading. As the dividends market is smaller than both the interest rate
market 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 owing
the lower market size and potentially lower liquidity, and that we need to adjust for this. A response to this is
that this still means the price of a security should be higher than the present value of the dividends, as per the
dividend 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 by
assuming that the curve is flat after the last traded maturity. Normally, for the dividend discount model, it is
expected that the dividends would be known out to infinity. However, one might imagine that the expected
economically active lifespan of the reader would not much exceed 50 years, and that therefore 50 years may
be thought of as infinity for these purposes. As discussed already, the present value would be found by
discounting 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.
10
0
Dec 08 Feb 09 Ap r 09 Jun 09 Aug 09 Oct 09 Dec 09 Feb 10
-2
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 2019
and it traded at 123.6. To extend the curve out to 2059, assume that the dividends between 2019 and 2059
would 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 2019
and 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 to
grow in the long run according to inflation and real growth. It is possible to counter this by pointing out that it
might be difficult to imagine natural buyers for a bullet dividend payment in 30 years – except perhaps for
those engaged in matching long-term liabilities with assets. The latter is a quite an objection, however, given
the current predilection for buying of steepeners on the dividend curve at every dip, it seems difficult to
conceive the dividend market being ready to accept a flat let alone downward sloping dividend curve. On
balance, 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 an
index 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 added
day 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 the
aggregate price of the current constituents. As against that however, we note that the forward on the SX5E is
trading at a lower level than the spot (as a function of the implied dividend yield being greater than the interest
rates) and so the argument that the dividend curve is too high with respect to the spot would remain valid.
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GlobalEquity-Linked: Delta One 30 April 2010