Wednesday, October 15, 2008

Evaluating Shares as Dividend Derivatives

An interesting point was made by a Dominic Connor (hat tip Infectious Greed) regarding what a share in a company actually was:

A share is itself a derivative, composed of several underlyings: capital value changes, dividends, an option that it might be taken over upping the price, and a set of entertaining variable tax consequences, since dividends and capital growth/lose are taxes quite differently from each other and for different classes of investor.
Lets dumb this down and evaluate an equity share solely from the value of it's dividend (click here for some good reasoning as to why dividends may be preferable to earnings for valuation purposes).

Point #1) Dividends are... Uncertain
Unlike traditional fixed-rate corporate bonds, in which an investor receives an agreed upon coupon, for an agreed upon length of time, at which point the principal is returned (bear with me and ignore default risk), an equity investor is not guaranteed a dividend or principal payback of any amount. In fact, we have recently witnessed just how easy it is for a corporation to halt or reduce dividend payouts (why all banks aren't all freezing dividend payments NOW while they are capital raising is beyond me.) Thus, the denominator in the price to dividend model (the dividend) is far from certain. In fact, 121 corporations in the S&P 500 do not currently pay a dividend.

Point #2) The Value of a $1 Worth of Dividends is... Uncertain
Looking at historical dividend payouts of the S&P 500 and the corresponding "derived" price in which investors were willing to pay for the S&P 500, we see shares have become significantly more expensive over the past 15+ years in these regards. From 1962-1992, investors paid no more than 40x the value of the dividends received (the average was a much lower 27x over that time frame for a ~4% dividend yield).

Since 1992, investors have paid as much as 88 times each $1 worth of dividend in exchange for equity ownership. At the end of 2007, investors valued shares of the S&P 500 at more than 50x each $1 of dividend for a yield of less than 2%. The current dividend yield is estimated at just under 3% post-equity collapse (though expected dividends are likely still overstated) and varies widely (i.e. less than 20% of companies in the S&P 500 offer a dividend yield above 5%, which is still about half the average yield of investment grade corporate bonds).

Conclusion
Both the denominator (the dividend) and the price multiple in the price to dividend ratio are at risk. Dividends are at risk due to a slowing global economy and frozen credit markets, which breeds lower earnings and capital hoarding, while the '50x per $1 of dividend' multiple is at risk when an investor can move up the capital structure and receive a 9-10% yield on investment grade debt.

In other words, Paul's satirical comment may not be all that far off...
Sneaky of capital markets regulators to be trying to trick us into going from safe credit default swaps over to tricky derivatives like shares. Those things sound nasty.