Walter's Model To start off with the Walter's model, let's go through the basics. Dividend is a part of the after tax profit for a company and that part of after tax profit is divided into the shareholders of that company. And the remaining of the PAT is called as "Retained Earnings". Therefore if the dividend pay-out is high, the retained earnings will be lower.
If a company thinks that by investing its retained earnings it will generate more than the market returns, then it should retain higher profit and should not pay more dividends (or also may not pay dividend at all). Other way around, if a company is not so confident that it will not be able to generate more than the market returns, it should pay out more dividends (or 100% dividends). There are two reasons for doing this:-
Shareholders usually prefer early inflow of cash
Shareholders also believe in investing this cash to generate more returns (since market returns are expected to be higher than returns generated by the company).
How Does Walter Model Work?
. He has given a formula in which he has delivered a way by which dividends can be used to maximise the wealth proposition of the shareholders. Considering a long run situation, according to Walter, share price gives an idea about the present value of future stream of dividends. Retained earnings influence stock prices only through their effect on further dividends.
Assumptions
There are some assumptions that we need to consider before implementing the formula proposed by Walter. These assumptions are:-
The company is a going concern with perpetual life span.
For this company, retained earnings are the only source of finance and it doesn't have any other alternative of finance.
The cost of capital and return on investment are constant throughout the life of the company.
If there is an additional investment taking place, then firm's business risk doesn't change. (This means that 'r' (internal rate of return) and 'k' (cost of capital) are constant.)
The firm has an indefinite life.
Walter's Model (Formula)
P = D
Ke - g
Where:-
P = Price of equity shares
D = Initial dividend
Ke = Cost of equity capital
g = Growth rate expected
After accounting for retained earnings, the model would be:
P = D
Ke - rb
Where:
r = Expected rate of return on firm's investments
b = Retention rate (E - D)/E
Equation showing the value of a share (as present value of all dividends plus the present value of all capital gains) - Walter's model:-
P = [D + r/Ke(E - D)] / Ke
Where: D = Dividend per share and E = Earnings per share
Example 1
A Ltd. paid a dividend of INR 10 per share for 2009-10. The company follows a fixed dividend pay-out ratio of 35% and earns a return of 19% on its investments. Cost of capital is 12%. The expected price of the shares of A Ltd. using Walter Model would be calculated as follows
EPS = Dividend / pay-out Ratio
=10 / 0.35 = Rs.28.57
According to Walter Model,
P = [D + (E - D) x ROI / Kc] / Kc
P = [10 + (28.57 - 10.00) x 0.19 / 0.14] / 0.14
P = 251.44
Example 2
These are some facts given for a company
Cost of capital (ke) = 0.12
Earnings per share (E) = $13
Rate of return on investments ( r) = 9.2%
Dividend pay-out ratio: Case A: 60% Case B: 30%
Show the effect of the dividend policy on the market price of the shares.
Case 1:-
D/P ratio = 60%
When EPS = $13 and D/P Ratio = 60%, D = 13 * 60%= $7.8
P = {7.8 + [0.092/13]*[13 - 6]} / 0.12 = $65.41
Case 2:-
D/P ratio = 30%
When EPS = $13 and D/P Ratio = 30%, D = 13 * 30%= $3.9
P = {3.9 + [0.092/13]*[13 - 3]} / 0.12 = $38.9
Conclusion
If r > ke, then the value of shares will be inversely related to the D/P ratio.
If r < ke, the D/P ratio and the value of shares will be positively correlated.
When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this case, there is no optimum D/P ratio.
Gordon Growth Model
The market value of the firm to dividend policy can be explicitly related by this model. In this model, the current ex-dividend at the amount which shareholders expected rate of return exceeds the constant growth rate of dividends.
Assumptions
It is based on the following assumptions:
The firm is completely financed by equity and it has no debt.
No external financing is used and investment programs are financed by retained earnings.
The internal rate of return, r, of the firm is constant.
The discount rate, ke, for the firm remains constant.
The retention ratio (i.e. % of earnings retained), b, is constant. Thus the growth rate, g = br, is also constant.
The discount rate, ke, is greater than the growth rate, g.
According to Myron Gordon, what is available at present is preferable to what may be available in the future. Being rational, the investors want to avoid risk and uncertainty. They would prefer to pay a higher price for shares on which current dividends are paid. However, they would discount the value of shares of a firm which postpones dividends.
Formula
The relationship between dividend and share price on the basis of Gordon growth model is as follows:
Where
V = Market price per share (ex-dividend)
ke = cost of equity capital (Expected rate of return)
Do = Current year dividend
g = constant annual growth rate of dividends
Example 1: Starlite Ltd. is having its shares quoted in major stock exchanges. Its share current market price after dividend distributed at the rate of 20% per annum having paid-up shares capital of Rs.10 lakhs is Rs. 10 each. Annual growth rate in dividend expected is 2%. The expected rate of return on its equity capital is 15%.
Calculate the value of Starlite Ltd.'s share based on Gordon's model.
Answer:
Another Form of Formula
When the growth is incorporated in earnings and dividends, the present value of market price per share (Po) is given by:
Po = Present market price per share
E = Earnings per share
b = Retention ratio (i.e. % of earnings retained)
r = Internal rate of return (IRR)
k = cost of capital
Example 2: Calculate the market price of a share of a company by dividend growth model (Gordon Growth model) for the given data:
Earnings per share (EPS) = Rs. 10
Cost of capital (k) = 20%
Internal rate of return (IRR) on investment = 25%
Retention ratio = 60%
Answer:
Market price per share,
Advantages
The primary advantage of this model is that readily available or easily estimated inputs are used to perform the valuation calculation.
The model is particularly useful among companies or industries having relatively stable and strong cash flows; and having consistent leverage patterns.
It has wide applications in providing guideline fair values in mature industries - viz. Financial services and large-scale real-estate ventures.
Disadvantages
One of its drawbacks is that it takes no account of qualitative factors such as industry trends or management strategy. For example, even in a highly cash-generative company, near-future dividend payouts could be capped by management's strategy of retaining cash to fund a likely future investment. The simplicity of the model affords no flexibility to take into account projected changes in the rate of future dividend growth.
It is less suitable for use in industries that are rapidly growing like software or mobile telecommunications. This is because the basic premise is that future dividends will grow at a constant rate in perpetuity.
Graham and Dodd Model
Introduction
Dividend policy of a company is very crucial in order to maintain good relations with the investors (specially the shareholders) of the company. When a company makes a profit, the management decides on what to do with those profits.
They have the option of retaining the profits and reinvesting them so as to earn more profits and increase shareholder wealth in terms of increase in share prices or paying the profits earned as dividend to shareholders so that the shareholders can have some cash in hand.
However, once the company decides to pay dividends, it should establish a permanent dividend policy, which may impact on investors and perceptions of the company in the financial markets. Generally, companies paying dividends are respected by the shareholders given the liquidity preference theory. If the company thinks that it has enough investment opportunities and they would be able to substantially increase the value of the company for the shareholders, it should retain the profits. What they decide depends on the situation of the company now and in the future. It also depends on the preferences of investors and potential investors.
Factors Favouring Higher Dividend Payout
AGENCY COSTS- Agency costs are differences between the interests of stockholders and the interests of management. More external capital is required to pay higher dividends. This leads to a greater scrutiny in the market therby reducing agency costs.
"BIRD-IN-HAND"- This argument holds that future earnings are less predictable and more uncertain than dividends, at least because they are further in the future. The greater uncertainty of future earnings should be reflected in a higher discount rate on capital gains than on dividends. This in turn would cause investors to prefer a more certain $1.00 of dividends over a less certain $1.00 of future earnings.
"PROSPECT THEORY"- This argument suggests that investors have a different attitude toward capital gains than toward dividends. Capital gains become part of the investment base or permanent capital, which investors hesitate to reduce. Paid dividends, however, are considered as current income and are spendable. Because "homemade" dividends require reduction of capital, they have a different psychological impact than paid dividends and are an imperfect substitute.
Factors Favouring a Lower Dividend Payout
TAXES- Although both capital gains and dividends are taxed, the tax on capital gains is lower and will not be paid until the stock is sold. Since payment of capital gains tax can be delayed, investors will be reluctant to create dividends by selling stock. Investors attempting to undo a dividend payment by buying stock with dividends must pay taxes on the dividends, and cannot totally reverse the dividend. The investor will be better off if the firm retains the earnings and reinvests them to produce capital gains, since tax payment is deferred.
TRANSACTIONS COSTS- In addition to taxes, investors reinvesting dividends will also face various transactions costs such a brokerage fees. Conversely, a firm that pays dividends and then must turn to external sources also faces transactions costs such as the "flotation costs" of issuing new securities. If the firm retains the funds and reinvests directly, both types of cost are avoided.
Other Considerations
DIVIDENDS AS A RESIDUAL- The argument for dividend irrelevancy assumes that all investment takes place at the required rate of return for the firm. In actuality, it is likely that the firm faces a mix of risk and return possibilities. The firm should thus accept all projects with a positive net present value, and pay dividends only if it has more funds than are expected to be required for attractive projects. While attractive to academics, this approach is seldom used in practice because it results in uncertain dividends and a greater perception of risk by investors.
CLIENTELE EFFECT- The clientele effect indicates that investors will tend to hold stocks whose dividend policy fits their needs. That is, investors preferring more certain dividends over uncertain future earnings, or having a preference for current income over capital gains, will tend to hold stocks with relatively high dividend payout, and vice versa (i.e., a stock will have a clientele attracted by its dividend policy). Under these conditions, it is not the dividend policy itself that is relevant, but the stability of the policy.
SIGNALING- Most theoretical models assume that information is freely available to all. It has been suggested that in reality access to information varies. Management may have access to inside information, causing an "information asymmetry" between management and stockholders. Signalling refers to the use of dividends and dividend changes to convey information to investors. Similar to the clientele effect, it is not the absolute but rather the relative level of dividends that is important. Under this argument management will avoid increasing dividends unless it is highly likely that the higher level of dividends can be maintained. This implies that a dividend increase is a signal that the firm has reached a new level of profitability, and is a positive signal. A dividend decrease, on the other hand, indicates that profitability has decreased and the former dividend level cannot be supported, a negative signal. Note that under the residual argument, however, a dividend increase (decrease) signals a lack (abundance) of attractive projects and decreased (increased) future firm growth. Because of the potential for false signals, more costly signalling is considered more reliable.
Graham and Dodd Model
Graham and Dodd Model holds that the stock market favours companies, which give more dividends than on, retained earnings. Hence an investor should evaluate a common stock by applying one multiplier to the portion of earnings paid out as dividends and a smaller multiplier to undistributed profits. In other words, more weight should be put on dividends than on retained earnings.
Their viewpoint is expressed as
P=m x (D + E/3)
Where,
P = Market price/share;
m = multiplier;
D = DPS;
E = EPS
Assumptions
The main assumptions of this model are:
Investors are rational.
Under conditions of uncertainty they turn risk averse.
Implications and Criticism
The main implication of this model is that weight attached to dividends is equal to four times the weight attached to retained earnings.This can be shown by re-arranging the above formula:
P=mx (D + (D+R)/3)
The weights provided by Graham and Dodd are based on their subjective judgements. So the conclusion of this model is that a liberal payout policy has a favourable impact on the stock price.
Example
Alpha Ltd. has recorded an EPS of Rs. 6 for 1998-99. The company follows a fixed dividend payout ratio of 75%. If the multiplier for the industry is 12, compute the expected market price for the share based on the Graham-Dodd Model.
Solution
The dividend per share is Rs. 6 * 0.75 = Rs.4.50
Based on the Graham-Dodd Model, the expected market price would be
P = m (D + E/3)
= 12 (4.50 + 6/3)
= Rs. 78 per share.
