Takeover Valuation: Dividend Policy
Whilst takeover activity should be guided by profit opportunities, the role of dividend policy must be factored in to satisfy shareholders expectations and attract potential shareholders from competitors once the acquisition is complete. So, an earnings valuation should be compared with a dividend valuation based on distributable profits (net of tax and an allowance for ploughback).
Since dividends convey information to the stock market concerning likely future earnings (dividend signaling) this forecast distribution may be defined as:
The expected dividend payout expressed in monetary terms, based upon either the dividend yields of similar firms, or their return on nominal value (dividend percentage) multiplied by the shares' market value.
This figure will give the highest valuation based on rational dividend expectations post-acquisition. To illustrate this rationale, let us consider the following purchase data:
We shall assume that:
(i) Pre-tax earnings are expected to be £20 million per annum (i.e. zero growth).
(ii) The retention rate is 80 percent
(iii) The earnings yield is 15 percent, equivalent to a P/E reciprocal of 6.66.
(iv) The dividend percentage on nominal value shares for similar firms is 6 percent.
(v) The rate of Corporation Tax is 25 percent.
With all this information we can calculate:
(a) Going concern valuations based on an earnings yield or P/E ratio
(i) V = Market capitalisation = Post-tax earnings x P/E = £20m (1 - 0.25) x 6.66 = £100m
(ii) P = Price per share = Market capitalisation / Number of shares = £100m / £5m = £20
(b) Going concern valuations based on the par value dividend percentage
The target company's actual dividend distribution is determined as follows:
The expected dividend is six percent of the nominal share capital value:
£50 million x 6% = £3 million
So, the predator company can define:
V = Forecast total value = (Actual dividend / Expected dividend) x Market capitalisation
= £3.0 million / £3.0 million x £100 million = £100 million P = Forecast value per share = Forecast total value / Number of shares
= £100 million / 5 million = £20
You will observe from the previous data set that knowledge of actual and expected dividends changed nothing. The dividend and earnings valuations were equivalent.
Given your appreciation of the inter-relationships between share valuation models, as well as the investment ratios dealt with in Part Two, can you explain why?
You will recall that if a company pursues a full distribution policy (Et= Dt) with a dividend yield equal to the earnings yield (Ke) and P/E reciprocal (1/ Ke):
P0 = current share price
Et = constant EPS per period
Dt = constant periodic dividend per share
Ke = common capitalisation rate for earnings and dividends
P/E = 1/K
It is obvious that price (Po) and hence the market capitalisation of equity (V) will only converge if a unique relationship exists between the dividend yield, earnings yield and P/E, relative to dividend distributions and profits after tax (dividends plus retentions) respectively.
To explain why, let us first analyse the inter-relationships for the previous data set.
(i) Whilst the return on nominal value (dividend percentage) is 6 percent the return on market value (dividend yield) is 3 percent.
(ii) The dividend percentage is twice the yield because market value is twice the nominal value, (think about it!).
(iii) Since the retention rate (ploughback) is 80 percent, the dividend payout ratio is 20 percent. Hence, dividend cover is five.
(iv) If earnings cover dividends five times it follows that a dividend yield of 3 percent must be equivalent to an earnings yield of 15 percent.
(v) Since the earnings yield is the reciprocal of the P/E ratio, the P/E must equal 6.66.
Armed with this information, it is no accident that our previous earnings and dividend valuations are identical.
If the dividend yield and actual dividend are both a fifth of the earnings yield and post tax earnings respectively, it follows from Equation (32) that:
V = 3 million / 0.03 = £15 million / 0.15 = £100 million Moreover, if the actual dividend conforms to the expected dividend in similar firms in similar industries: V = (Actual dividend / Expected dividend) x Market capitalisation = 1 x £100 million = £100 million
To prove that dividend and earnings valuations may also diverge, use the previous data set to confirm that:
If the expected dividend percentage for similar firms was 5 percent, the dividend signaling effect of an actual £3 million distribution post-takeover would cause the share price to rise from £20 to £24 per share.
First, we can revise the market capitalisation of equity by adjusting the original earnings valuation of £100 million relative to an expected dividend of 5 percent, rather than 6 percent, on nominal share capital.
V = Forecast total value = (Actual dividend / Expected dividend) x Market capitalisation = £3.0 million / £2.5 million x £100 million = £120 million
Thus, the market price per share is defined as follows
P = Forecast value per share = Forecast total value / Number of shares = £120 million / 5 million = £24
However, it must be emphasized that an earnings valuation is the prime motivational factor for investors seeking control of a company. As we also observed in Part Two, based on the pioneering work of M.J.Gordon and Modigliani and Miller (MM), the role of dividend policy as a determinant of equity value (for acquisition pricing or any other purpose) still remains a fundamental point of disagreement among academics and financial analysts alike.