Dividends and buybacks are set to return this year. How can analysts examine the underlying value of an organization?
Corporations have responded to the onset of the COVID-19 epidemic by reducing costs and increasing liquidity.
In the United States, non-financial entities now hold 2.6 trillion in cash, equivalent to 5% of total assets. Which dropped from an all-time high of 6% last summer. Meanwhile, the net debt-to-EBITDA ratio is much lower than in previous decades.
US corporate cash / assets
As earnings increase and the larger economy begins to recover, companies are ready to place their cash through capital expenditures (capex), mergers and acquisitions (M&A), and cash gifts to shareholders in the form of dividends and buybacks.
According to Bloomberg’s unanimous estimates, earnings for the S&P 500 will increase by more than 50% in 2021, and Goldman Sachs has forecast a 5% and 5% increase in dividends and buybacks, respectively.
Cash returns should be a significant driver of stock returns, especially in such low interest rates. In fact, dividend and buyback stocks started to do better than the S&P 500 in early 2021.
Buyback and Dividend Stock vs. S&P 500
Although shareholders generally benefit from cash gifts, the application and utility of such transactions varies by company.
Cash returns should increase the internal value of an organization. The question is how to determine if a particular gift achieves that goal. This requires a multi-step assessment framework that answers three questions:
1. Does the company have potential Capex, R&D, or M&A activities on which its cash will be placed?
Assessing perspectives for an organization’s specific projects is a clever initiative: the spectrum of such activities runs gamut and investment details are not transparent or universal. Nevertheless, history can be a useful guide.
Has the company struggled in the past to generate capital (ROC) returns over cost of capital (COC)? If so, that trend could continue unless potential projects differ significantly from their predecessors. If COC vs. ROC is expected to be less, then cash gifts become more attractive.
For companies with a brief history, analysts can look at the original Capex project or M&A. For the former, there should be a positive net current value (NPV). For M&A, in order to add value at the highest level, the adjusted NPV target should be higher than the premium paid above the company’s internal value.
2. How much money can the firm allocate for givebacks?
To determine the amount of expenses assigned to a company’s shareholders, it is a good metric to look at free cash flow (FCF) generation and financial leverage. The higher the FCF margin of a company, the more latitude it will have to repay. The market exhibits an FCF margin at the top and a relatively strong FCF generation at least.
But FCF variability also needs to be evaluated. The main drivers of FCF instability are the growth phase of the corporation and the compounding of its sector. An early-stage high-growth company will typically have fewer and more sporadic FCFs than an established company. Corporations with revenue and profitability are strongly tied to economic activity, there will also be more variable FCF.
Three methods help to assess a company’s debt level and whether it has been finally, under, or properly recovered:
- Comparable: This simple method weighs the debt ratio of a company compared to other companies in the same industry.
- Negative operating profitability: This method determines an acceptable level of credit risk based on credit historical finance or considering the worst case scenario based on future financial projects. The default risk of acceptable levels, the target credit rating and the minimum credit ratio must be met in order to comply with the bond agreement.
- Reduce capital costs: This is the most theoretical method but helps surround the analysis. The optimal balance of debt for equity reduces capital costs and therefore maximizes the value of the internal firm. How? Identifies the minimum weighted average cost of capital (WACC) by combining the cost of a firm’s debt, or interest rate, and the cost of equity, or the rate of interest required for shareholders, for each mix of firms / equity.
By triangulating these approaches, analysts can determine an optimal leverage level.
Combining the perspective with its cash flow and leverage profile for a firm’s projects can suggest an overall return strategy. The following matrix displays four mixtures:
Calibrate the ability to provide cash
|Bad project||Good project|
|Strong free cash flow||Increase giveback
Collect cash for new investments
|Poor free cash flow||Reduce the gift
|Reduce the gift
Note: If the companies are under or overliver, the gibbacks can be ward up or down accordingly.
Source: Wealth Growth Group
Those. Should those backups be dividends or buybacks?
The final step in the process of determining the best form of cash return. For dividends, firms should have strong FCF generation without unreasonable variability and have exceeded their fastest growth stage. Explains dividend change as a signal from market management. It often reads the beginning of a dividend which means the long-term growth prospects of a company fade. Benchmarking can provide useful insights against dividend yields and similar agency payments.
The suitability of a buyback depends on the answers to the following questions:
1. Is the stock worthless?
If an equity trades below its intrinsic value, it is a good investment, and it makes sense to buy back the shares.
2. What is the growth stage of the firm?
If the company is going through a period of rapid growth when it is investing heavily, buying shares may be appropriate.
3. Does the firm have a cyclical industry?
If so, buyback flexibility may take precedence over their dividends.
4. How important are employee stock options to attract and retain talent?
Many companies, especially in the tech sector, have to buy shares to provide alternatives to their employees and offset the share delusion.
5. Is the rate of tax on capital gain different from dividend?
The tax rate varies according to the type of investor. Currently, long-term capital gains are taxed at the same rate as dividends.
In the United States, there are legal proposals to raise taxes on high-earning individuals and corporations. It is difficult to predict the political outcome, but the decision to buyback vs. dividends should not actually change the fact that the rate of return on capital should be increased on investors less than 1%. Increasing the corporate tax rate will hurt the FCF but will also increase the ability to borrow more to create interest expense taxes.
With a record high level of corporate cash balance, companies can continue to increase their cash disbursements for the benefit of shareholders. But investors need to be aware that while givebacks are usually a good idea, some are better than others.
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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.
Photo Credit: © Getty Images / Champs
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