Show me the cash and I'll tell you the value, says Uliana
March 25, 2009
By Etienne Swanepoel
Enrico Uliana was appointed the executive director of finance at the University of Cape Town (UCT) in 2001. He was previously the head of UCT's department of accounting and is the co-author of the leading South African textbook, Financial Management, now in its 22nd year of publication.
Uliana's main academic interest concerns valuations, and he still teaches the valuation elective on the MBA programme at the UCT Graduate School of Business.
In an interview last week, I sought to find out how the current global economic crisis has affected company valuations.
A constant theme in his book is that the guiding principle for valuations is the present value of future cash flows. In the words of Uliana: "Show me the cash. A company, apart from share buybacks and capital reductions, can only pass on its cash flows to shareholders in the form of dividends."
It follows that "changing expectations about the growth of future dividends can have a significant impact on value".
He adds: "Where are the cash flows and what are the risks? The value is simply the net present value of future expected dividends. Dividends are only a function of future earnings and expected growth.
"Here, history is a reasonable indicator of the future. Your expected earnings are made up of how you apply retained earnings and your leverage policy.
"What is risk? This is determined by what business you're in, that is, your operating risk, and your financial leverage. Again, where is the cash, where is the risk? I have a concern if I can't see the cash. I want to know what backs the cash, that is, what is the quality of the earnings. What elements of your earnings are cash or a function of accounting practices, and what elements are constituted by your debtors book? Are the earnings maintainable?"
According to the book, the dividend decision is one of three distinct decisions taken by management that affect the sustainable growth rate of firms. The other two are investing and financing decisions. A firm's capital structure is a mixture of equity and debt. Paying a dividend reduces retained earnings and the capacity for leverage. By paying out dividends, a firm denies itself capital, which it will have to raise elsewhere to invest in profitable projects.
Uliana explains the debt-to-equity ratio. "If you have a 50:50 ratio and you retain R100 earnings, you have the capacity to invest R200. The remaining R100 will be funded from debt. If you make R1 000 profit, you can gear another R1 000, so your total investment capacity amounts to R2 000.
"On the other hand, if you have an investment opportunity of R1 500, and your profit amounts to R1 000, you can pay a dividend of R250 inasmuch as you can gear R750. Add this to your retained earnings of R750, and you have your required R1 500."
According to Uliana, "very few companies apply this approach in the short term. Over the longer term, firms tend to revert to a preferred debt-to-equity position or their risk profile changes."
The book asks whether the dividend decision affects a company's value along with the investment and financing decisions. Or is the dividend just the consequence of the other two decisions? If it is the former, the dividend decision must be managed actively; if the latter, it is irrelevant.
This latter, residual approach to dividends takes the view that a dividend should only be paid if the company has no other use for the funds. In this school, payment of a dividend suggests that the company has exhausted its growth opportunities.
On the other hand, "the payment of dividends has information content. Investors use many sources of information to evaluate a company. The financial statements are a valuable source. However, the information is historical. Reported earnings can be subject to manipulation or simply distort the position, as accounting statements may provide for different interpretations.
"So the announcement of a dividend, or lack thereof, contains relatively clear information about the company's health, in particular if there is an unexpected change."
The dividend becomes a signal of the company's well-being. "There are so many choices in formulating financial statements, how do you convey that this is a good profit? The signal is only good if it hurts me to send a signal that proves to be wrong.
"A signal that my results are moving up a gear is that I am increasing my dividends. This is a better signal than announcing an increase in earnings. Why? If you have an increased profit and you increase your dividend, then reduce it the next year, you lose credibility. If you increase your dividend, shareholders conclude that the level of earnings is maintainable. You are saying that the quality of your earnings is sound.
"The dividend policy may signal a new level of confidence. Remember, it's always about the cash, and the only way you get hold of the cash is by way of a dividend, a liquidation dividend, or a sale. So dividends are typically a signal by management of the company's state: the signal is captured by the change of the dividend. If I don't believe management, I simply increase my discount rate applicable to the share."
The signalling effect should not get in the way of sound financial practices.
"Dividends are the ultimate distribution of the wealth of the company. But the dividend will depend on the drivers of the underlying value."
On whether investor behaviour could drive dividend policy, he advises that there remains the so-called clientele effect: "Shareholders will be attracted to a company that satisfies their needs with regard to the balance between cash income and capital. For example, pension fund shareholders will be looking for stable returns."
He cautions that "companies should not pay dividends to satisfy the wrong shareholders. These shareholders should rather switch to the right company."
In regard to the global financial crisis, he asks to what extent people are over- or underestimating risk. "If you have easy times, you tend to adjust your world view with recent history. People think the good times will continue. They reduce the risk premium. They reduce the discount rate.
"Now, the markets are the opposite of euphoric. But be aware of double counting. In a depressed market, estimates of future earnings and cash flows are pessimistic. At the same time, you say, 'I'm feeling bad about the future' and increase the discount rate.
"Value is determined by dividing the expected cash flows (or expectations of future earnings) by my required return or cost of capital. By decreasing growth and increasing the required return, one could be double counting the same piece of news. Thus, good news could be overvalued or bad news could be overpenalised."
Uliana's ability to reduce complex issues into simple frameworks is a signal of his expertise and skill. He also has the deceptively simple ability to translate the complexities of his discipline into digestible concepts.
Etienne Swanepoel is a partner at Webber Wentzel. The opinions expressed are his own.
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