No value from the right-hand side of the balance sheet?
At almost all business schools around the world, the one thing students can expect for sure is that their professors will tell them in corporate finance, investments, and even financial strategy, that significant value can be created for shareholders in a number of different ways, all on the right-hand side of the balance sheet. Of course, this refers to dividend payouts, stock splits, share buybacks and, of course, borrowing money. Let us take them one at a time, but before I do, I should warn you to batten down the hatches.
Last year Professor Eugene Fama of the University of Chicago won the Nobel Prize in Economics principally for his work on the subject called Market Efficiency, which has to do with how quickly new information enters the marketplace and is decimated and translated into new share prices. This overlooks the fact that Fama has published more than 250 scholarly papers in academic journals over his 50 year career, which has all been spent at the University of Chicago, first as a research assistant to Merton H Miller of Miller & Modigliani fame, and later as his collaborator on the brilliant book, “The Theory of Finance,” that was published back in 1972. The reason I raise Fama’s name is that he gave a brilliant lecture to the MBA students at the University of Chicago approximately two years ago, in which he pointed out that he is not permitted to teach corporate finance courses in the Booth School MBA program, because he believes that no value is created on the right-hand side of the balance sheet. In my opinion, once you have a chance to think about it all, you will conclude the very same thing. The big question should be why all professors of finance do not feel the same way.
Let us look at dividends first. When cash dividends are paid out, this subtracts from cash available for making new investments, the present value of the returns on which are already in the price of the shares. This means if dividends are paid out, the price of the shares must fall at least by the amount of the dividend paid out. Furthermore, if the projects that are forgone by paying dividends are those that create positive net present value (NPV), which means a premium of market value over book value on such investments, the result must be that the price of the shares will fall by more than the dividend paid out, because of the extra return that is being forgone from these high returning projects. Of course, if the project only earns the required rate of return for risk, also known as the cost of capital, this means that such projects have zero NPV, and thus the price of the shares will fall by the amount of the cash dividend paid out. The conclusion from this is that dividends gained are equal to capital gains lost. It is simple and straightforward: No value created.
Stock splits actually have a negative impact on shareholders. It turns out that when firms split their shares, the liquidity in the shares is reduced, because the volume of shares traded does not keep pace with the split. A good example was IBM several years ago when they split their shares at $300 4-for-1, so that the shares immediately thereafter traded at $75. The problem is that in order for liquidity to be maintained on the same basis as existed before the split, the volume of shares traded would have to quadruple so that the same dollar value of shares are trading. This did not happen. In fact, the volume of shares traded was slightly less than double, which means the liquidity virtually dropped in half. This is not a good idea for shareholders, especially for firms whose volume of shares traded are much, much less than that of IBM. I should also point out that brokerage commissions in the U.S., despite all of the high technology now used, are higher the lower is the price per share, so that splitting shares means that the commissions paid by shareholders for buying the same dollar amount will have increased, thus also hurting the shareholders.
How about share buybacks that seem to be all the rage? Why would the price of the shares go up with a share buyback, because the share buyback has the same impact on cash and investment opportunities inside the firm as does the payment of cash dividends. The answer is that if the market assumes management is squandering resources inside the firm — that is, surplus is being used to subsidize poor returning projects that should not be undertaken at all — then a share buyback or a dividend disgorgement will have the exact same impact. The value of the firm will rise because “agency costs,” the cost of monitoring and disciplining management, will be reduced, because the resources available for management to invest in poor returning projects will have been reduced.
The argument in favor of share buybacks creating value is based on a silly notion. It is that both the earnings per share of the company and its return on equity will increase. The problem with this argument is that disgorging resources from the firm reduces the present value of projects that then are not undertaken, the same argument as was used before in discussing cash dividends.
In my next discussion early next week I will explain why debt is not cheaper than equity despite the fact that the interest expense is tax deductible. It will come as a big surprise. Frankly, it came as a surprise to me when I began to realize just why this must be the outcome.