The Dividend Advantage

Paul Donahue is managing director in the global markets capital group at Morgan Stanley in New York.

The utility industry generally attracts investors who have a dividend focus. Retail investors own utility stocks for the dividend income, and institutional investors own them in income portfolios. Every  investor group in this sector considers dividend income when evaluating the investment merits of a particular stock. 

In the last few years, however, power companies as a group began paying out a smaller portion of their earnings. Instead, they allocated capital to growth opportunities and strategic activity—they expected diversified activities to create more shareholder value. Many shareholders have been quick to point out that capital for strategic activity outside the regulated business has not historically been a shareholder value-creating practice. A well known industry analyst for a large mutual fund complex has summed it up best: “In general, nonutility investments have earned very low returns on capital…and reinvestment opportunities in the utility ratebase are not that significant.”

But dividend programs have regained sway, helped in part by the Jobs and Growth Tax Relief Reconciliation Act signed last May. In fact, the Act has profound implications for the power industry. It cut the tax rate for both dividends and capital gains received by an investor. If he holds a stock at least 60 days, the tax rate on his dividends will be 15 percent rather than the highest ordinary rate (formerly 38.6 percent; now 35.0 percent). The Act also reduced the 20-percent tax on net long-term capital gains to 15 percent.

In essence, this change eliminated the historical tax bias toward the creation of capital gains at the expense of current income. This change will also affect how shareholders value equities, which in turn will have implications for the cost of equity capital.
It is clear that investors are paying increased attention to dividends. It is also clear that investors have returned to traditional valuation models. What is less obvious is the impact of dividend tax relief on these models. For the power industry, this is likely to be significant, and that’s why companies need to reevaluate dividend policy today in the context of current shareholder views, rating agency concerns, and long-term value creation.

From Dividends to Buybacks
During much of the last century, tax policy gave most companies meaningful incentives to create shareholder value through capital gains rather than by distributing earnings directly to shareholders. Still, at least until the 1990s, power companies had few opportunities to redeploy earnings into businesses with strong growth prospects. As a result, those companies paid out a large percentage of their earnings in the form of dividends. As earnings grew, so did dividends.

Another reason for those high-dividend policies was the relative unattractiveness of stock buybacks. Since regulated utilities (unlike most companies in other industries) earn returns based on their equity base, shrinking that base through stock buybacks has negative implications. In essence, utilities did not have the same opportunity as other industries to convert earnings into the more tax-efficient capital gains.

But by the mid 1990s, the American economy was strong, companies in many sectors were growing rapidly, and perceived high-growth businesses (trading, merchant generation, etc.) proliferated. For the first time the market viewed power companies as having a new use for earnings: growth. Dividend payout ratios began to decline as earnings were redeployed to create more shareholder value. (See Figure 1.) Power stocks suddenly were more than simple income investments: They were growth stories as well.

With declining payout ratios and greater prospects for growth, some management teams felt their companies were creating more value than what their stocks reflected. Companies across the board recognized the potent combination of flexibility and tax efficiency unique to stock buyback programs. In fact, this trend became so pronounced that the dollar volume of announced and completed buybacks actually equaled the amount of dividends paid in 1999 for the market overall. (See Figure 2.) Indeed, even the utility sector saw share repurchases begin to approach dividends that year.

The Buyback Rationale
When ordinary income was taxed at rates far exceeding that of capital gains, the debate of buybacks versus dividends was a one-sided argument. The Tax Relief Act has now balanced the debate. But there are still several differences between the two options that may make one or the other more attractive to power companies.

Before the Act, the primary rationale for companies to pursue buybacks over dividends was that the former represented a more tax-efficient way of returning capital to shareholders. Although this advantage no longer exists, there are several other benefits of stock buybacks that continue to be equally (or even more) important for companies to consider.

Flexibility is a key benefit. A company can announce a buyback, execute it slowly (open market) or quickly (tender), and change terms and timing as it sees fit. Also, it can then choose what portion, if any, of the buyback to execute (though shareholder displeasure for not completing an announced buyback can be severe). This nearly unlimited flexibility can distort clear corporate finance thinking. Instead of using buybacks to distribute value to shareholders, under- performing companies often use the programs to support their stock price. Although you can argue that this is a form of value creation, the investment community sometimes perceives it simply as corporate (and management) preservation. Nonetheless, when it comes to distributing capital to shareholders, flexibility remains an important rationale in selecting a stock buyback over a dividend increase.

Buybacks also allow shareholder self-selection. In other words, a shareholder can choose how to accept the distribution of value. By selling stock into a buyback, a shareholder theoretically receives a higher price for the stock than he would have otherwise. By not selling, he effectively reinvests in the company since his post-buyback pro rata ownership of it is greater.

Companies also like buybacks because they help manage the impact of new equity issuances, particularly those arising from the exercise of stock options. In the last decade, stock buyback programs were a good response to rising equity values and corporate America’s increased use of options as employee incentives.

Dividends and the Clientele Effect
Still, returning capital to shareholders through a recurring dividend has always had advantages over buybacks. And now that the primary argument against dividends has been resolved (the inequity of the tax on ordinary income versus capital gains), the benefits of dividends have become even clearer.

Those benefits derive from the “clientele effect,” that is, the buying or selling of equities that occurs when a company policy—e.g., on dividends or governance—changes. In the case of dividends, there are actually two effects. The first is shareholder signaling—dividend increases traditionally signal management confidence in future cash flows. Stock buybacks, on the other hand, tend to signal management’s belief that the stock is undervalued. This is a subtle yet important distinction for power companies.

The clientele effect’s second component relates to shareholder-base expansion. There is very little capital that can invest only in nondividend-paying stocks. On the other hand, there is a large pool of capital specifically chartered to invest in those that pay dividends. Thus, even a modest dividend can significantly expand the universe of potential investors. This may explain why dividend-paying companies experience significantly less turnover in the market than their nondividend-paying peers. (See Figure 3.)

That reduction in churn is another benefit of dividends: The lower turnover of shareholders leads to lower stock price volatility. (See Figure 4.) This has important implications for a company’s cost of capital.

The Rating Agency View
Now that the tax inefficiency of dividends is no longer an issue, the view of dividends by rating agencies takes center stage. Indeed, with 279 corporate downgrades in the electric utility sector since January 2001 and $30 billion of equity capital raised in the same period (most of which went to improve the industry balance sheet), the ratings agencies seem to be single-handedly driving the industry’s finance decisions, including dividend policy.

The primary agency concern regarding dividends is the extent to which they are a cash commitment: The dividend, although not factored into coverage or balance sheet ratios, might detract from cash flows that could be used to cover interest expense or reduce overall debt levels. By increasing the payout ratio to return more cash to shareholders, companies may be limiting their fiscal flexibility.

“We don’t think of dividends as a fixed charge,” says John Whitlock, a director with Standard and Poor’s (S&P). “We think about them in terms of a company’s overall financial flexibility and financial policy. There is no formal model or way in which we model dividends in viewing a credit. Our ratings committee views each company on a case-by-case basis.”

Dan Gates of Moody’s has a similar view: “One of the key measures of financial flexibility is cash flow after capital expenditures and dividends.”

Yet ratings agencies do have some concerns about power companies increasing their payout ratios. “It is too simplistic to say that the combination of low payouts and tax relief on dividends means that power companies should increase their payout ratios,” says Whitlock. “In our industry, it is paramount to focus on flexibility. A dividend increase in one year that is subsequently reduced may result in diminished access to capital markets.”
At the same time, both S&P and Moody’s worry that power company management teams consider dividends sacred and are reluctant to reduce them in times of duress. “We consider a dividend as being unlikely to be cut by management unless under extreme pressure,” says Moody’s Gates. “There is a long history of investors being focused on dividends [in the utility sector] and management teams keeping them intact during times of diminished financial flexibility.”

The Investor’s Measures
Investors seem to be encouraging power companies to increase payout ratios. In part, this is a function of investors wanting current return in a low-return world. However, the burst of the internet bubble in the equity markets has also led to significant changes in investor thinking. These changes are not simply reactionary: They represent a return to the approaches that existed prior to the bubble. As such, they should remain steadfast even in the event of another phase of dramatic power industry growth.

Investor irrationality during the height of internet mania is well known. Cash was not king, and seemingly all companies, including power companies, reported financials based on earnings that derived from generally accepted accounting principles (GAAP). Investors signaled Wall Street that they wanted to focus on quarter-to-quarter growth in earnings, and management teams had incentives (through stock options) to deliver on earnings growth targets. And who could blame them? The market was valuing equities based on perceived earnings growth. As recently as May 2001, Mirant (the spin-off from Southern Company) actually had a higher market value of equity than did its former parent primarily because of perceived growth rates. Further, companies financed acquisitions with leverage, choosing to ignore (or at least postpone addressing) potential balance-sheet implications. After all, equity values were only going higher, so why worry about capital structure? 

The market has obviously returned to some of its sensibilities—in many ways, in fact, it has improved on them. Driven by investors, corporations today focus on transparency. Acknowledging the shortcomings of GAAP earnings, many companies now use “free cash flow” and “return on invested capital” (ROIC) as their primary metrics. (See “A Metric Glossary.) Those companies are proactive and preemptive in thinking about their liquidity needs—they keep a tight rein on their commitments. The days of driving the capital allocation process to achieve quarterly projections are gone. Many companies now only provide annual targets to buyside and sellside analysts; these same analysts are returning to time-tested valuation tools with which to assess stocks.

A METRIC GLOSSARY

Discounted cash flow Net present value of a firm as calculated by discounting the unievered free cash flows of a company and an assumed terminal value Dividend discount model Valuation model that estimates the current value of all future dividend payments Free cash flow Earnings accounting for capital spending in the year it occurs, not in terms of depreciation. Intrinsic value Value of a firm as calculated by a discounted cash flow analysis Levered beta Beta is a measure of risk relative to portfolio of securities or an index. Levered beta is the relative risk of a stock accounting for the debt (leverage) of the company's capital structure Price-to-earnings ratio Price of a company's stock divided by the earnings per share. A measure of the valuation of a company relative to a unit of earnings Return on equity Net income divided by the book value equity Return on invested capital Net income after taxes divided by (total assets minus cash and noninterest-bearing liabilities) Sharpe ratio A ratio to estimate risk-adjusted return. Calculated using standard deviation ad excess return to determine reward per unit of risk. The higher a Sharpe Ratio, the better the risk-adjusted return Terminal value The remaining future value of a firm at the end of a time period. encompassing remaining value of cash flows plus scrap value and /or perpetual growth Unievered free cash flow Net income, depreciation, amortization, deferred taxes, working capital, and writedowns, minus capital expenditures and after-tax interest expense Weighted average cost of capital Cost of a company's capital, calculated by adding the company's cost of debt and the company's cost of equity in proportion to their respective percentage of the overall capital structure

Instead of earnings growth, investors and companies in the power sector are using ROIC, intrinsic value (that is, discounted cash flow—DCF), and dividend discount (DD) models (along with price-to-earnings ratios—P/Es) more frequently to value companies. In other words, the market has returned to incorporating risk when assessing returns. Although it was rare to hear of common concepts that measure risk (for instance, Sharpe ratios, levered betas, etc.) during the internet bubble, one certainly does now. One portfolio manager of a large utility fund said his group relies almost solely on a multi-stage DD model when assessing relative value among utility stocks. Others still adhere to P/E-based relative value calculations.

But many savvy portfolio managers use a range of techniques in assessing relative value while giving a nod to the recent emphasis on dividends. “We use many measures,” says Evan Silverstein of Silcap. “Most recently, we have been focusing on both dividend discount and total return models to try and compare segments of the industry. Determining what is important to investors at different points of time is always a challenge.”

Taking a WAAC
DFC models used by many analysts and investors are almost always pre-tax relative to personal tax. In the model, corporate tax rates apply to cash flows, but not personal tax rates. Few CEOs and chief financial officers (and fewer buyside investors) would allocate capital based on a DCF model, which adjusts for taxes at the individual shareholder level. Even DD models rarely incorporate personal tax rates when discounting future dividends paid to investors.

So where does the change in dividend tax rates manifest itself in these tried-and-true valuation tools? The answer lies in the discount rate.

Whether using a DCF or DD model, you have to make an assumption with respect to the cost of equity. The cost of equity, in turn, is a key component in arriving at the weighted average cost of capital (WAAC) that many power companies use as the discount rate in a DCF model. Even in a DD model, the cost of equity is a key driver.

To arrive at the cost of equity, you must determine the equity risk premium for the investment or market. The tax assumption on dividends can materially alter the calculation of equity risk premium. Conceptually, the analysis is straightforward: If an equity investor demands a certain after-tax equity risk premium above a risk-free rate, allowing that investor to keep a  more current return (by lowering the dividend tax rate), then he requires less growth, all else being equal. Tax relief on dividends ensures that the investor keeps more current income and therefore is willing to accept lower returns (through growth) to achieve the required after-task equity return. In Table 1, you can see that ABC Power Company has a pre-tax risk premium of 4.81 percent under the old tax rules. Based on the new tax rules (and  other assumptions being equal) the pre-tax risk premium falls to 3.29 percent

TABLE 1
ABC POWER COMPANY'S PRE-TAX RISK PREMIUM (in percent)
Assumptions	Prior tax rule	New tax rule
Personal tax rate on ordinary income	35.00	15.00
Personal tax rate on capital gains	20.00	15.00
Risk-free rate (30-year Treasury bond yield)	6.00	6.00
Equity risk premium	4.00	4.00
Dividend yield on utility stock	5.00	5.00
1. Compute the after-tax return on the risk free rate:
Risk-free rate times (1 minus the personal tax rate on ordinary income)	3.90	5.10
2. Compute the required after-tax return on the equity:
After-tax return on the risk-free rate	3.90	5.10
Plus the equity risk premium	4.00	4.00
Equals the after-tax return needed for the equity	7.90	9.10
3. Determine the components of the equity return:
Dividend yield on utility stock	5.00	5.00
Adjust for personal tax rate on ordinary income	35.00	15.00
Equals after-tax dividend yield	3.25	4.25
After-tax return needed for the equity (assume this does not change)	7.90	7.90
Minus the after-tax dividend yield	3.25	4.25
Equals the required price appreciation	4.65	3.65
Adjust for personal tax rate on capital gains	20.00	15.00
Equals the pre-tax price appreciation needed	5.81	4.29
4. Calculate the pre-tax risk premium:
Dividend yield	5.00	5.00
Plus pre-tax price appreciation	5.81	4.29
Equals pre-tax return on equities	10.81	9.29
Minus the risk free rate	6.00	6.00
Equals the pre-tax risk premium	4.81	3.29

In its most simple form, ABC Power Company has seen its WAAC decline. How? If the pre-tax equity risk premium falls, then so does the cost of equity. If the cost of equity declines, so too must WAAC (all things being equal). Companies that pay large dividends will see the new tax law’s greatest impact on WAAC.

“Dividend tax relief lowers the cost of equity,” says an analyst at a large dedicated utility hedge fund, echoing the belief of many investors. “Whether you use the capital asset pricing model or DD to measure the cost of equity, in theory, the required pre-tax return has decreased,” yet investors still demand the same after-tax return. Silcap’s Silverstein agrees: “I do believe the cost of equity has been reduced, reflective of the fact the total return to investors has gone up on an after-tax basis.”

But some caution that this could be a fleeting benefit. “[Dividend tax relief] may lower a utility’s cost of capital in the near term, but that could impact a regulator’s view,” said Bill Tilles of Jemmco Capital. “If the regulators see this as an opportunity to pass on a benefit to the ratepayer classes, then there is no long-term benefit” to utilities resulting from tax relief.

What does this mean for companies? It means that just as investors have differing views on the benefits of a dividend increase, companies must realize that there is no universal answer. Instead, each company must carefully assess the strategic, financial, and regulatory implications of dividend policy in light of the company’s own situation.

The Core of the Issue
Ultimately, there is a cost to increasing the payout ratio for power companies, and it is not theoretical. A dollar of free cash flow that is paid out as a dividend is unavailable to be reinvested to earn returns for shareholders in the future or to pay down debt and improve the balance sheet. As such, the dividend debate is really not about dividends versus buybacks. Nor is it simply about appealing to the current buyside “flavor of the month” (a trend likely to reappear because, after all, at some point investors will focus on growth again). And whether a rating agency might frown on a payout increase should not be a primary decision driver, either. The dividend debate should simply be viewed as a capital allocation and return of capital decision.

According to finance theory, non-dividend paying companies can be expected to grow at a level equal to their earnings, multiplied by their return on equity (ROE, as a proxy for the reinvestment rate). XYZ Technology Company, with $1 of per-share earnings and an ROE of 10 percent, should grow at 10 percent (assuming it reinvests all its earnings and does not pay any dividends). On the other hand, ABC Power Company, with its aforementioned 4-percent dividend yield, would grow at a slower rate than XYZ, even with the same ROE characteristics. If you assume that the 4-percent dividend represented a 40-percent payout ratio, then ABC Power only has $0.60 for each $1 of per share earnings to reinvest at its ROE—and thus have a 6-percent growth rate.

Does this imply that ABC Power will have a relatively worse valuation in the public market than XYZ Technology? Of course not. But it also does not mean that each company will have identical valuations. As the power industry knows well, many factors can explain equity valuations—and not all the explanations are necessarily rational. The timing of cash flows, the riskiness of flows created by operating or financial leverage, and so forth, all factor in “real world” equity valuations. Since the Act effectively increases the post-tax dividend component of total returns to investors, thereby decreasing the required return from capital gains, it can change the way companies evaluate their opportunities: Now, they can provide the same total return despite lower-growth, lower-risk investments.

Will investors give management the benefit of the doubt in selecting where to reinvest those earnings? The effects of over-extending into nonregulated businesses have taken their toll on analysts’ perceptions. “Over the past several cycles, utility managements have generally not shown a consistent ability to generate nonutility returns commensurate with the incremental risks undertaken,” says Jemmco’s Tilles. Another portfolio manager agrees: “As a rule, we do feel that utilities should increase their payout ratios. The underlying reason is related to rate-base regulation and the industry’s poor record of diversification/investments outside the regulated base.”

But in environments where marginal returns on reinvested capital exceeds WAAC, companies can create value by deploying retained earnings back in the business. Leslie Rich, senior industry analyst at Banc of America Capital Management, sums it up well: “With returns on investments (such as new gas-fired plants) not earning their cost of capital, it should make companies more receptive to distributing dividends as a means of increasing shareholder value.”

A Logical Catalyst
Understanding the primary and secondary implications of dividend tax relief is more important for power companies than those in nearly any other sector, since they pay out a large part of their earnings as dividends. But the Jobs and Growth Tax Relief Reconciliation Act has done more than simply change the tax rate for dividends and capital gains. It has direct implications for how power companies compute their cost of equity and thus make capital allocation decisions.

These issues, in turn, affect other decisions ranging from capital structure to project evaluation to investor relations. Tax relief on dividends is a logical catalyst for industry participants to review dividend policy thoroughly, and thereby re-evaluate their strategic direction. 

© 2008 Edison Electric Institute