A critical evaluation of the DVM and the CAPM.

Q-1 Critically evaluate the Dividend Valuation Model (DVM) and the Capital Asset Pricing Model (CAPM) and using the models estimate the values of your chosen company. Critically compare the estimated price with the current market price and comment on what may be a fair offer for the shares of your chosen company and state your qualified recommendations.

Q-2 Evaluate the dividend policy literature and assess the impact of the changing economic environment in the UK on dividend policy of the company.

ANSWER TO Q-1
The Dividend Valuation Model (DVM) and Capital Asset Pricing Model (CAPM) are the most common approaches to estimating the cost of equity, the third being arbitrage pricing theory (Choudhry et al. 2001). Gordon’s (1959), dividend model states that the value of the share is the present value of the future anticipated dividend stream from the share, where the future anticipated dividends are discounted at the appropriate risk-adjusted cost of equity (Beninga & Czaczakes, 2001). DVM is made on the assumption that dividends grow year on year and the manager pays dividends in line with the growth of the company. Hence DVM is more appropriate to use for companies that have a stable dividend policy (Fabozzi et al. 2003). DVM gives a more realistic picture for those companies that give dividends from free cash flows, at least on an average basis. Companies with a mature business and stable earnings usually fall into this category. Fabozzi et al. (2003) raises the question as how to calculate the cost of equity if dividend growth is not constant because DVM does not allow accommodate non-constant growth easily.

Damodaran (2007) argues that DVM‘s strict adherence to dividends as cash flow exposes a serious problem. Sometimes companies hold back cash and don’t pay dividends to invest in future projects. The cash builds up in the company’s reserve and shows as cash reserve. The stockholder may not be able to claim cash as such, but the value of cash will be shown in the price of equity of that company. The DVM ignores cash balances and undervalues companies with large cash reserves.

On the other hand the company may show constant dividend payouts or high growth in dividends by raising debt or fresh equities. The DVM may produce higher valuations of these firms instead of the actual one (Damodaran, 2007).

DVM assumes that recent past dividend growth is an indicator of future dividend growth. Lumby and Jones (2003) object to this inaccuracy of data input i.e. estimation of future growth of dividends from the past growth of dividends. Moreover DVM does not work when the company pays no dividends or they are all time historically low e.g. during an economic downturn. Dell computers in the USA never paid dividends and International Power in the UK has stopped paying dividends in future as a matter of policy. Neither of these firm has zero value (Neale & McElroy, 2004).

Shiller (1981, quoted in Damodaran, 2007) presented evidence that the variation in share price is far too high to be explained by variance in dividends over time. This is becausemarket values of share prices fluctuate far more than the present value of dividends. The figure for the equity cost is dependent on the day they are obtained, because share prices fluctuate on daily basis. The need to take into account past dividends paid by the company and its historical share price make the use of DVM relevant only for the listed companies.

If growth exceeds the required rate of return, the model gives a negative valuation of the share, which does not make sense. Furthermore, calculating the value of a company growing faster than the economy, where this growth rate is expected to last a few years, is also a problem. There are business cycles and we need to look at those cycles to estimate the long-term growth rate in earnings and dividends (Correia et al. 2007). But Damodaran favours the use of DVM for companies where obtaining an estimation of cash flow is difficult e.g. banks and financial institutions.

CAPM is other viable alternative to the Gordon model for calculating the cost of capital. DVM looks at the equity cost facing the firm as a whole, as does the CAPM, but the CAPM is also capable of using risk premiums for specific activities. The use of beta also plays a crucial role in it (Neale & McElroy, 2004).

Despite the widespread use of the CAPM, the model’s empirical reliability has been widely challenged. Studies have shown that, at an investment portfolio level, the relationship between beta used by the CAPM to measure systematic risk and actual equity returns do not support the predictions of the model. The model’s problems are increased when it is applied to individual securities, due to the difficulty of accurately measuring betas for individual assets (Urken, 2005).

The model’s empirical shortcomings arise from the fact that the only viable means of applying the CAPM is in conflict with the theory that underlies the model. The CAPM is based on the relation between the expected future premium on equity investments over risk-free assets and the expected future covariance of individual equities against a market index (beta). However, the only practical way to measure these inputs to the model is to rely on subjective estimates based on historical results as a proxy for actual future expectations (Urken, 2005). For the CAPM, beta is based on past performance. There is no certainty that the future will be like the past.

The CAPM has provided investors with a tool to calculate expected return on equity and at one time it was the ‘work horse’ for one generation of practitioners. But the evidence that high beta stocks do not earn higher returns than low beta stocks lead some to the view that the ‘horse is dead’ (Stern & Chew, 2003). But Kamaiah (1998), who carried out the test for the CAPM on 53 stocks listed on the Bombay stock exchange by considering Bombay Stock Exchange sensitive index as market index from 1991 to 1994, came up with the conclusion that beta is highly significant for all securities and there is a strong positive relationship between individual stock excess return and market index.

The CAPM as derived by Sharpe (1964) is a single period security pricing model i.e. the rate of return is calculated over a single time period while the DVM is a multi time period model. The CAPM is also a single-factor model i.e. it may not be capturing all the determinants of the return. It predicts a linear relation between security betas and expected returns, with no other variables affecting the security prices. Contrary to one factor CAPM, other variables may be needed to describe more completely the cross-section of expected returns (Lumby and Jones, 2003).

Early studies by Blume (1971) and Gonedes (1973) found that risks drift over time (quoted by Howton & Peterson, 1999). Therefore Howton and Peterson (1999) criticise the assumption placed on the CAPM to perform empirical tests and not recognising that the trading environment is dynamic. When the risk is assumed constant, the CAPM does not completely describe the results generated in a dynamic environment.

Also, there is an anomaly when trying to find security returns using the CAPM, called size effect. It has been found the common stock of companies with small market capitalisation i.e. price per share times the number of shares outstanding, produce higher returns than companies with high capitalisation, with other things being constant (Horne & Wachowicz, 2004)

Despite criticism and counter-evidence, the CAPM remains a widely used model. If the dividend growth is stable, the DVM is better the model (Baker, 2005). Warren Buffett, one of the world’s most successful investors, says: – “to invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging market (quoted by Correia et al. 2007)”. If the opinion of an investor like Warren Buffet is taken into consideration, the models do not seem to have any importance. To conclude, it can be said that the use of the DVM or the CAPM for asset price calculations has flaws but these seem to be inevitable tools to use to estimate the price of a security.

CALCULATION OF PRICE USING THE CAPM AND THE DVM FOR GREGGS PLC
Ryan (2007) explains that the Gordon Growth Model can be used to predict the share price using historical data. The share price prediction is based on the historical data, so there is the possibility that estimated share prices may not be accurate. Greggs Plc has been taken as a case study to predict the share price using five years of historical data. The two important components to estimate the price is; dividend growth (g) over the selected period and the cost of equity, which will be calculated with the help of the CAPM.

Ryan (2007) elaborates some limitations of the Gordon Growth Model, that in the long run rate of growth (g) should not exceed the investors’ required rate of return when discounting dividends. While analysing the financial data of Greggs Plc we can see that the dividend growth rate is 12%, whereas the investor required rate of return is 4.2%.

John et al. (2007) explain that if r < g, dividends grow faster than they are discounted, so the value of the stock is infinite. Pike & Neale (2006) state that it does not make sense to calculate the price when r < g because the denominator will become negative and will show an infinite result. It is quite evident from the discussion above that future price for Greggs Plc cannot be estimated due to the limitations of model.

Scoltz et al. (2007) defines stock beta as the measure of how much the returns on a particular security, portfolio or fund vary with the market as whole. The bigger the beta coefficient of a security, the higher the volatility of that security. The stock beta calculated on the basis of the 5 year historic data is 0.49 as compared to previous year beta of 0.39. In spite of an increase in beta, the company share price is not that volatile compared to the food and drug retailer sector. The cost of equity for Greggs Plc is 4.2% calculated using the five-year UK gilt rate of 2.85% on 9th July 2009, whereas a 5.69% return on market has been shown using the average of FTSE 250 index.

ANSWER TO Q-2
Madura & Fox (2007) suggest that maximising shareholder’s wealth is the main objective of any firm. Investors expect a reward for the risk they undertake. Shareholders can be rewarded in two ways; either with dividends or with capital gains (The Economist, 1992). Dividend policy generally refers to the policy that determines what amount is to be paid to the shareholders. Baker et al. (2001) suggest that dividend policy is a payout policy, which determines the size and the pattern of payments to shareholders over time. Holder et al. (1998) suggest that there are contrasting views on how dividend policy affects the value of a firm. They add that some scholars such as Gordon (1959) believe that dividends increase shareholders wealth, whereas some, such as Miller & Scholes (1978), suggest that dividends are irrelevant and researchers like Linzenberger & Ramaswamy (1979) propose that dividends reduce shareholders wealth.

Olson & McCann (1994) suggest that the absence of perfect capital markets make dividend policy an important source of information to investors. The authors add that according to dividend signalling model, dividends signify information about the level and riskiness of future earnings. The management has the dilemma of whether to pay dividends or not and how much to pay. Fabozzi & Peterson (2003) suggest that firms are generally reluctant to cut dividend as it can lead to fall in its share price.

According to Dividend Irrelevance Theory given by Modigliani & Miller (1961), payments of dividends do not affect the value of the firm. The theory suggests that the dividend decision only affects the financing decision and is a residual decision. If a firm does not have any profitable investments to undertake then the firm can pay that amount as dividends (Fabozzi & Peterson, 2003). However some theories suggest that paying dividends can be beneficial for a firm. Rozeff (1982) and Easterbrook (1984) propose that dividend payments can reduce the agency costs of external equity (quoted in Deshmukh, 1997). Jensen (1986 quoted in Deshmukh, 1997) argues dividend payments prevent investment in projects with negative NPV, which some managers may undertake and hence reduce agency costs. Whereas Residual Theory suggests that dividends should be paid only from funds which are not required for investment purposes (Higgins, 1972, quoted in Deshmukh, 1997).

The dividend policy of an organisation depends on many factors and one of the concerns is taxation. In markets where dividend income is taxed at a higher rate than capital gains, different payout policies are preferred by shareholders in different tax brackets (Brennan, 1970; Ferrar & Selwyn, 1967, quoted in Allen & Izan, 1992). Dividend clientele effect (Miller & Modigliani, 1961) argues that a company’s reluctance to change their dividend policy is due to the fact that their shareholders will have to change their portfolio, which would be an expense to them (Allen & Izan, 1992).

The changing economic environment can affect the dividend policy of an organisation. Marks and Spencer, the 125-year-old retailer, recently announced that it will rebase its dividend payment from 22.5p a share to 15p a share. It described it necessary as its profit before tax fell from £1.1b to £706m this year (BBC, 2009).

Aviva Plc cut its dividend by 40% in 2008, which will allow the company to avoid raising fund through rights issue (Telegraph, 2008). Similarly, Carpetright cut its dividends from 22p in 2008 to 4p in 2009 as sales have reduced and profits have shrunk (Telegraph, 2008).

Lawlor (2009) stresses that various dividend cuts have dented the confidence of British investors (FT, 2009). The number of companies scraping dividends has grown from 13 in 2008 to 48 in 2009. In 2008, 50 companies in the FTSE-100 reduced their dividend payments, whereas 33 of FTSE-100 firms reduced their dividend payments within the first quarter in 2009.

However, even this period of global recession, Royal Dutch Shell has announced a 5% increase in their dividend payout. Shell, which hasn’t cut its dividend payout since World War II, once considered dividend cuts mainly due to falls in price of oil and hence loss of revenues. But later it said that it will increase debt to cover its dividend if necessary (WSJ, 2009). Clifford (2009) also stresses the importance of dividends, especially during the downturn. The investor today is more concerned with how a company is going to perform in a tough climate (Investmentweek, 2009).

“The biggest issue is when you lose dividends that are less cash going into households, which is less cash being spent. As the recession deepens, unemployment rises and consumer spending slides, dividend cuts are one more negative factor weighing on the U.S. economy” (Reuters, 2009).

Arend (2007) emphasises the importance of dividend paying companies, especially during a downturn because shareholders keep on receiving dividend payments. One type of investor has special cause to ignore the theory of the irrelevance of dividends. Income unit trusts, which account for nearly £7 billion ($12.6 billion) of the £56 billion stored in Britain’s mutual funds, depend on dividends for their survival (Anon, 1992).

The annual dividend increase is a strong signal to investors that the company is continuing to grow. But in reality, however, annual dividend increases aren’t always possible. In order to declare dividend increases, the board of directors must be satisfied that the earnings are, or will be, there to support the dividend. Various economic factors such as inflation, interest rates, economic growth or other factors can depress earnings of firms to a level that will not support an increase in dividends. During these times the board may decide to give up dividend increases. The ultimate challenge to companies in this scenario is deciding whether to give dividends to shareholders to attract investors or keep the cash with the company for its future growth.

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