A couple years ago I was asked to help in an assignment where the client was unhappy with the performance of its share price. He wanted advice on what the company could do to help spur shareholder returns. On the internal brainstorming call, the lead banker teed up his idea to recommend a massive dividend hike to boost dividend yield and, by extension, total shareholder return.
Seems like a fairly straightforward recommendation in light of the fact that the equation of total shareholder return (“TSR”) is often written as:
TSR = capital gain + dividend yield
Unfortunately, it is also completely wrong. But this naive interpretation of the TSR formula is, sadly, a common misconception among practitioners of corporate finance. Dividends do not directly affect TSR. This is because there is a deterministic relationship between dividends paid per share and share price (and therefore capital gains). On a stock's ex-dividend date, its market price, by definition, drops by the amount of the dividend per share, so any increase in dividend yield is directly and exactly offset by a commensurate proportionate reduction in capital gain, resulting in a neutral effect on TSR.
So, why has something seemingly so simple confounded so many of the top rainmakers in investment banking? To understand that, it is important to understand what TSR, the metric, really is. TSR was invented to measure all sources of return to an equity investor, thereby facilitating the comparison of the overall performance (IRR) of investments in securities with differing dividend (and growth) profiles. In other words, the equation above represents a normalization technique, not a structural, causal relationship.
To try and evince the true drivers of shareholder return, an equation in terms of fundamental growth and market’s valuation thereof is more instructive. For example, choosing price / earnings as the key valuation indicator:
TSR = change in EPS × change in P/E
This is still fairly naive (after all, P/E is also just a normalization technique, in that it scales observed valuation, rather than a true valuation technique) and can also be subject to misinterpretation. For example, the clever financial engineers among this post’s readers may already be thinking that a share repurchase that reduces share count could inflate EPS, resulting in a positive change that, assuming no change in multiple, could generate price appreciation. Wrong again. Share repurchases do not directly affect TSR. Leaving aside the impact on share count (which basically cancels out since it is in both the numerator and denominator of a P/E ratio), a share repurchase contracts the P/E multiple because market capitalization drops by the amount bought back, while net earnings fall by at most the marginal interest expense of debt funding. Any cash returned through share repurchases, therefore, has no immediate effect on stock price and consequently, TSR.
Once all the technical effects on share price, earnings per share, and multiple are stripped away, all that matters is the market’s expectation and valuation of fundamental performance. True earnings / cash flow growth can only be achieved through operational efficiency and value-additive investments in organic and acquisition-fueled expansion. The repricing effect (multiple expansion / contraction) includes stock market volatility that is largely out of the company’s control, but it can be managed through effective communication and transparent disclosure.
Coming full circle, though it took a bunch of explication and cajoling, the relationship manager in question finally saw reason, and we went in with a pitch advising that focusing on operational initiatives to spur growth is a much better way to drive TSR than financial engineering.
I don’t want shareholder payout to get a bad rap though. Although shareholder distributions won't artificially inflate TSR, they can still drive enhanced returns when used in a value-maximizing way as part of a holistic capital allocation process. A robust, yet prudent, shareholder distribution policy can be value-additive and thereby drive enhanced returns in a number of ways:
- Deployment of new debt proceeds or excess balance sheet cash towards shareholder distributions can help optimize a company's capital structure and unlock shareholder value
- If the stock is undervalued, repurchasing shares at a market price below intrinsic worth can transfer value to the remaining shareholders if the price converges to its warranted value
- When communicated appropriately, announcements around payout policy can send favorable signals to the market and generate positive stock price reactions
That being said, shareholder payout remains a residual use of funds that is likely only to create marginal value; operational excellence and intelligent investments in growth will always be the true sources of value and drivers of market performance and TSR.
Let me know if you have any thoughts at firstname.lastname@example.org.
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