Companies around the world are seeing economic meltdown. At this situation the investors fear the most. The organizations loose the shareholders money, resulting in dwindling stock market and lack of trust in the economy. The economy of business is quite hard to understand at certain stages. It becomes important for an investor to analyze the business well in perspective of the economic condition and invest accordingly. It is not only the individual investors who face the dilemma, even the corporate investors and financial houses are in similar situation. There is no single reason that such economic downturn has occurred, but rather a host of problems that has taken the market completely unaware. To make things worse the liquidation of Lehman Brothers and the subprime crisis of the US housing market, has taken the world economy by surprise. Taking this situation in consideration and also regarding the economy at large it is important to note that the investor needs to be smart enough to know the right signals at the right time.
Each company has their own policy of running their financials. How they manage their business primarily lies with the policy that the directors and the CEO take. Most organizations have robust financials, with good quantum of paper profit. Also, with quite a few mergers and acquisitions seen in the recent past, proves that the cash flows of these companies are quite healthy. At the same time the companies have to maintain the values of the customers, shareholders and the employees. A company with high liquidity and substantial shareholder value is considered to be a healthy and growing company. This is quite evident, because even companies with high book profit, may not be cash rich. But some companies, like the telecom companies have good inflow of cash, but still incur substantial losses. This phenomenon has been faced by Vodafone, which made losses of £21.9 billion in May 2006, yet had solid cash flows to meet the requirements of its shareholders and other operating expenses. For a cell phone company, a sturdy cash flow is the most important aspect, even though the company may have paper losses.
Before going ahead with any further analysis of the subject we need to understand the following concepts:
- Cash-flow analysis
- Value-based analysis
- Share buy-backs
- Dividend policy
In this paper we will try to figure out why in certain situation the investor need to look more into the share buy-back and dividend policy options rather than the cash-flow or value-based analysis.
A company can have cash flows from various inlets and outlets. The primary areas are:
- Interest & taxes
While calculating the cash flow we need to consider the total inflow of cash and deduct the total outflow of cash to arrive at the net cash flow. The main inflow cash occurs from sales. Hence a company with high turnover most likely will have a positive cash flow. At the same time it is important to know the total outflow of cash. After a certain period of time, a company will have fewer outflows of cash as most of its assets will be in optimum running condition. Likewise the company will be in a breakeven stage and will incur less expense as compared to its inception days. Now let us consider an example:
Company A Company B
Year Cash flow ($million) Year Cash flow ($million)
1st 10 1st 15
2nd 11 2nd 16
3rd 12 3rd 17
In comparison it apparently looks like Company B has a better cash flow than Company A. But the below noted clarification will make things clearer.
Year OC ($million) + FC ($million) – IC ($million) = Net ($million)
1st 20 5 15 10
2nd 21 5 15 11
3rd 22 5 15 12
Year OC ($million) + FC ($million) – IC ($million) = Net ($million)
1st 10 5 0 15
2nd 11 5 0 16
3rd 12 5 0 17
Ø OC – Operational cash flow
Ø FC – Financial cash flow
Ø IC – Investment cash flow
What apparently seemed to be a cash rich company; in reality it is not. Company A had invested for the future and is reaping substantial cash flow from its core business. Hence, a company with a high cash flow need not be a very sturdy company.
Now let us look into the values that a company carries during its operating years. Since the company has to deal with many parties to ensure smooth functioning it needs to add value to the relation. The value in this case can not be substantiated how well the relation has been set, but what is the monetary values of the same. One of the most important values that any company needs to maintain is that of the shareholders value. Irrespective of whether the company is a public limited company or a private limited company, the shareholders need to have the value for their money. Most companies adhere to the same, but not all are able to do so. Over the years the companies have grown manifolds. In spite of many ups and downs most companies are at multinational levels and have spread across the globe. Hence, it is obvious that people around the world have discussed about them. Be it the economist, politicians, media or the business community itself. Thus it can be very well seen that each such community of people have their own viewpoint. The company has to meet their expectation and values.
It is quite evident that the company must look primarily towards profitability. But some people argue that the company has some social responsibilities as well. To be an ideal organization the company must give importance to both profitability and social responsibility. But such a situation to some extent contradicts each other. The corporations must earn high profits so as to give substantial return to the shareholders money. At the same time it must be somewhat safe and produce a better yield than a bank deposit. The stock prices, book profits are the signs of company is growing and the investors or shareholders can expect better ROI (return on investment) on their investment. The profit of an organization is not only a result on the books, but also a clear picture of the company’s wealth and health.
At the same time it is also certain that a company can not perform alone. It requires a team of dedicated workers and an efficient network of people and parties. All these aspects must work together to achieve a common goal. Employees are an important part of the company. They represent the major part of the company and attribute to the intellectual property of the organization. In order to have employees perform efficiently, the organization must constantly motivate them and give them the necessary impetus as and when required. In the same platform the other aspects must be taken care of. The external parties like suppliers, customers, government and other groups of people must have a sense of trust while dealing with the organization. Such trustworthy perception will grow security amongst all groups of people and stakeholders.
The shareholders will look into the profitability aspect more than the responsibility. The shareholder values the organization on the aspects of dividends, share prices and profits. For them the company is more responsible in making money rather than looking into the other aspects of social responsibility. As per the shareholders are concerned, the organization is responsible to maximize their wealth within the rule of the land. Other responsibilities like community work, employment generation, consumer welfare and other social development is up to the government and individuals to deal with.
But in respect to the perspective of a stakeholder the organization must be more responsible than be highly profitable only. It must look into the common interest of all the parties involved with the company. Stakeholders believe that the organization must satisfy the majority of the people and believe that social responsibility is an important aspect of the company. The company is not just the spokesperson of the shareholders, but a coalition of variable resources to achieve a common goal and create a common wealth in a symbiotic approach. The moral issue that the stakeholders’ advocates for the organization, is that a collective approach will result into improving the social health and in the macro level improve the economy.
Bearing such facts into consideration it can be deduced clearly that neither the value-based management, nor the cash flow analysis is the true indicator for a company’s health. It can differ in different economies and market. Also the perception might be different for an economy. Hence, such indicators are not trustworthy to a great extent. It might only provide a momentary assessment of the company, but in the long run the investor need to consider other aspects more minutely.
Dividend policy and share buy-back approach of company is at times an accurate reflection of the company’s situation and what it predicts for the company in the future. It must be understood, how the dividend policy works and why it is so important.
Dividend payouts occur when the company is unable to invest the extra cash at a higher rate of return than the shareholders themselves. If for example accompany earning 25% return on its equity, then it is advisable to retain the money as the shareholder will not be able to earn that kind of return from anywhere else. Again at the same time an investor might require cash to meet his expenses. In such situation the investor will not be interested to invest on a long term basis, but will like to reap immediate benefit. How much the company will pay as dividend will entirely depend on the assessment of the cash flow and how much the company decides to return to its investor? The percentage of the net income that is paid out to the shareholder in the form of dividend is known as the dividend payout ratio.
The dividend payout ratio is considered important as it reflects the company’s growth. The amount of dividend paid against the net income of the company will give the dividend payout ratio of the company. As an example we can sight that in the year 2003 Coca-Cola earned $4.347 billion as net income and it paid $2.166 billion against it to its shareholders. Thus it paid 49.8% as the dividend payout ratio.
At the same time it must also be calculated what the dividend yield is. It reflects what the investor is earning against his investments against the current market price. This is calculated in the following manner:
Actual or indicative annual dividend ÷ Current price of each share
Based on this calculation an investor can predict how much he will earn against each investment. For example:
If Company A pays a dividend of $8 against a share which trades at $1,000, then the dividend yield will be 0.008 or 0.8% .Company B pays $3 against a share price of $50, and then its dividend yield will be 0.06 or 6%.
Hence, it is quite clear from the above mentioned example that a company with a higher share price may not always give a better yield than a company with a lower share price. Thus for an investor it will be beneficial to invest in Company B.
Now we must look into the various aspects of share buy-backs. One of the most important reasons why a company would like to buy-back its own shares is that there are no other options to invest that exceed the Average Cost of Capital (WACC). It is a viable option for the company. Rather than investing into assets or investments which may not be futile, it is better to return some money to the shareholders. It also provides the shareholder an option to re-allocate the money from a mature market to growing markets, thus enabling the capital market to grow.
At this juncture one question that can come into anyone’s mind is that why not dividend. Instead of buying the shares back, the company can also pay rich dividend to the shareholders. Theoretically there is not much difference in this concept. But in practice there are some differences. In some situations paying a good dividend will get the job done, but in some scenarios the company benefits more with the share buy-back option. As per the company; paying a rich dividend means that, it has to pay higher dividends in the future as well. But in case of a share buy-back there are no such pressure points. In the long term perspective it is often seen that a buy-back is fruitful for the investor.
At the same time some situations also arise when such options are not in the proper interest of the shareholders. It is considered at some point in time that a bearish market is not actually bad. For some companies and its promoters the buy-back will be done with the company’s money. The personal fund is not utilized at all. And this also increases the stake of the promoter in the company. There are two views to this situation. For some the buy-back is an easy exit from the company, but for others, who had long term interest in the company, it is a harmful process. Most companies prefer to buy-back the shares when the prices are at a rock bottom rate. The same can apply for the bond market as well, but since the shares form the majority of the capital, hence it is a easy target for the companies. At the same instance it must be remembered that the company must have available cash balance so that it does not become a futile experience for the company.
Covering all this areas we can come to a certain conclusion. The cash flow of a company may not give the correct picture of the company. It will by merely be an economic outlook of the company which will not be a conclusive evidence for the investor to invest in the company. Similarly the values that the company portrays to its stakeholders and shareholders depict the concern or priority of the company. It not necessarily means that the company has the right kind of people to take care of its business. How the company deals in such circumstances can not give the investor an option to invest in that company. Since it is the internal matter of the company, hence it may not give investor the right details to invest in the company.
However, when we consider that the dividend policy of the company one can understand that the company has some serious understanding of the market. At the same time the company has given importance to the shareholders. The share buy-back is another area that the investor need to concentrate. Understanding the intent of the company is an important aspect of the company. Based on these areas the investor will take the right decision to invest in the company. Giving importance to the shareholders and making them the part of the company is what makes the company more reliable and trustworthy to the investor.
- Cash flow. 12 November, 2008 <http://en.wikipedia.org/wiki/Cash_flow>
- Cash Flow Statement Example and Components. 29 July, 2008. <http://www.mysmp.com/comment/reply/891#comment-form>
- All About Dividends. Joshua Kennon <http://beginnersinvest.about.com/od/dividendsdrips1/a/aa040904_3.htm>
- Shareholder Value Perspective versus the Stakeholder Value Perspective <http://www.valuebasedmanagement.net/faq_shareholder_stakeholder_perspective.html>