How should investors read a prospectus?

Investing Education | Comments (79)

How should investors read a prospectus?

I read recently that Kerry Stokes didn’t understand his company’s prospectus. What hope do retail investors have?

Kerry’s revelation emphasises the need for ASIC to intervene and make prospectus documents clear and concise. Last Thursday evening I shared my thoughts with Peter on Switzer TV. If you kept your copy of the Myer prospectus, watch the interview then flick past the first 28 pages of glamorous photography to the Pro Forma balance sheet.

What Value.able IPOs have you uncovered recently?

Posted by Roger Montgomery, author and fund manager, 28 April 2011.

INVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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79 Comments

  1. Gavin
    :

    Hi Ashley

    Difference between companies A & B at year 2 is: that Company A has $120 in contributed Capital whilst company B has $100 in contributed capital and $20 in retained earnings. Both have $120 in equity. Total equity will be the same every year, only the ratio of contributed equity to retained earnings will change.

    Given that companies A&B are identical apart from their payout policy and their total equity stays the same then their return on equity must stay the same.

    EPS does decrease as more shares are issued via the capital raising. From the shareholders point of view this is compensated by the fact they own more shares.

    In your example for company A year 2:

    I agree that EPS are 22cents but 22 cents times 108 shares = $24 earnings divided by the equity of $ 120 = ROE of 20%. I’m actually at a loss why you get it to be 18%. I assume you are incorrectly multiplying the 22cents by 100 shares not the 108.

    • Ash Little
      :

      Yes Sorry Gavin your are right but please do the maths out 10 Years. Company B will be the winner hands down.

      I know because I once thought like you but have seen the light.

      • Gavin
        :

        Hi Ashley

        You are going to have to spell it out for me exactly because I don’t see the light. In 10 years (or any other year) there will still be no difference in the equity or ROE. The only possible difference could be in the valuation model applied and here is where I think the difference lies.

        Rogers’s model is based on Walters’s dividend model. One of the limiting assumptions of Walters’s model and hence the Value.able model is that the firm’s investments are purely financed by retained earnings. With this limitation than yes it is better for a high ROE company to retain and employ capital rather than distribute it – because it has to be an either/or proposition. But that limitation doesn’t exist in the real world. I think this either/or limitation embedded in the model is blindsiding people to the fact that it is better for a company to payout profits to the limit of the franking account where shareholders are tax advantaged and re-raise the capital. What’s needed to see the potential is a model that accounts for capital employed by the company beyond just retained earnings.

        In the example we are discussing. Company A is valued by the Value.able model much lower because it has no retained earnings. Yet in reality its equity growth and ROE is exactly the same as Company B and so should be its value. It’s just that the model you are using does not account for the potential of new capital contributions.

      • Ash Little
        :

        Hey Gavin,

        I hope you get around to modelling what we have said one day,

        Take care

    • Gavin
      :

      Ashley

      Despite having no logical basis for expecting a difference, I have modelled the two scenarios’ out to 10 years just to humour you. (Roger how do I post a spreadsheet?)

      At year 10 company A has 222 shares on issue and earnings of 56 cents per share. A P/E of 12 results in a market cap of $1486.02. Company B has 100 shares on issue with earnings of $1.48 also resulting in the identical market cap of $1486.02 at a PE of 12.

      So absolutely no difference between the two companies which is only logical because they are both employing the same amount of capital at the same return. The only difference is that one (company A) distributes profits and then re-raises.

      If you go to the next level and look at the cash flows to the shareholder than you get the following:

      A shareholding held through superannuation in the pension phase.– 0% tax rate.
      IRR of 24.3% for company A and 20% for company B

      A shareholding held through superannuation in the accumulation phase – 15% income tax and 10% CGT
      IRR of 21.7% for company A and 19% for company B

      If you discount the cash flows at your re-investment rate then company A with its earlier cash flows has an even greater advantage.

      Much of the thinking on this topic seems to be out of USA where shareholders are tax disadvantaged from receiving dividends. The other clouding issue for many people here seems to be the limitation in the Value.able formula that a firm’s investments are purely financed by retained earnings. THIS IS NOT A REAL WORLD LIMITATION.

      I challenge you, Roger or anybody else that has tut-tutted a combination of fully franked dividend payments and capital raisings to produce a model that justifies your beliefs.

      • Ash Little
        :

        Hi Gavin

        Using your figures

        Company A share price is $6.72
        Compny B is $17.76

        I Know whick comapny I want nto put my money into

      • Gavin
        :

        Hi Ashley

        I gave the wrong earnings figure for company B in year 10. It should have been $1.24. Market price would be $14.86 (14.86*100 = market cap of $1486)

        $14.86 for company B still looks superior to $6.72 for company A. But you would own 222 shares of company B and 100 of company A. Multiplying shares held by market price gives you the same overall market valuation.

        So whilst both shareholdings have the same nominal market value in year 10. Company A’s shareholder would have also received the potential benefits of the imputation credits over the last 10 years and have a higher cost base for the calculation of GST.

        Just to make it perfectly clear – I am not saying that a company should choose paying dividends over growth. I am saying that it may be logical for them to do both – they can payout profits to unlock the tax advantages for shareholders and re-raise the capital to fund the growth.

        It would be in shareholders best interest to return the capital to those companies that can re-invest the new capital at a high ROE and refuse to re-invest in those generating low ROE on new investments. Imagine the increase in transparency management would have to provide if they needed to ask for capital back rather than what occurs now when management spends retained earnings.

  2. Frank
    :

    Hi Roger,

    Thanks for this post. I think it’s awesome. From many of my readings, the general slant is don’t buy an ipo as it is usually overpriced and risky. However recent findings have proved this wrong in some cases, MACA, MCE. Maybe you can put a section in your new valuable edition about prospectus and IPOs?? I think what you mentioned in the interview was invaluable , very simple. Yet I haven’t heard anyone say it like that before.

  3. Grant Duggan
    :

    Ash/Nick
    Would you mind checking my figures on TSM as i feel they are a bit on the high side, 2011 POR45 ROE25 EQPS27=87c. 2012 POR57 ROE30 EQPS31=$1.17
    2013 POR56 ROE35 PS38=$1.48

    • Peter M (Mully)
      :

      Hi Grant,

      My current valuations are as follows:

      2011: EQPS32c ROE25 EPS78c POR59 RR12 = $0.89
      2012. EQPS36c ROE25 EPS88c POR57 RR12 = $1.01
      2013. EQPS41c ROE30 EPS1.16 POR56 RR13 =$1.52

      That said, I don’t have much confidence in the forecast EPS numbers with the result that the forecast IV’s are probably a bit rubbery.

      Hope this is of some help

  4. ken fraser
    :

    Broker forcasts for MML for whoever is interested. Wilsons NP for 2011 $125m. Citi NP for 2011 $106m. Fairfax NP for 2011 $93.6m. Wilsons NP for 2012 $192m. Citi NP for 2012 $119m. Fairfax NP for 2012 $135.9m. Wilsons NP for 2013 $209m. Citi NP for 2013 $147m. Fairfax NP for 2013 $119.3m. Does anyone have some other Broker forcasts for MML. These three brokers differ a great deal from each other but I don`t exactly know why. From the MML half year report you would think the brokers would be in agreement and have a fairly similiar full year NP forcast for 2011 anyway. Wilsons forcasts are a lot higher than the other two brokers all the way through to 2013. Any comments on MML from anyone? Does anyone have Broker forcasts for RMS or know what broker follows them? I can`t get any forcasts for RMS. To me MML looks better than RMS as they seem to have more certain gold production for longer. Thanks a lot if anyone is interested in commenting.

    • Steve I
      :

      Ken,

      I own both MML and RMS.

      I’m happy to use the average eps forecast from yahoo finance. It’s a mix of the analysts that you have mentioned.

      I personally rate MML as the blue chip of asx gold producers. It doesn’t get too much attention, it is steady, it is reliable, it delivers consistently, has very sound management and seems to be viewed by the market as a boring producer as it seems to fly under the radar but just consistently grows production, cash flow and reserves. Given the co-O results, plus other large swaths of opportunities, this has the potential to be very very large. If you want a producer that had no debt, can grow organically and reliably with few surprises, MML fits the bill.

      It is my largest gold position. Regardless of broker forecasts, IV to 2013 provides a decent margin of safety. The biggest growth in value is to be after 2013. The potential is massive, but somehow also conservative.

      RMS 2012 should be around $0.22 per share and I think ROE should be maintained to 2013 as they are spewing out cash. The way I see RMS is that it has more potential than MML over the next 2 years (much bigger margin of safety), but doesnt have as much longer term potential (at present). RMS is has massive cash flow.

      Both are good. MML one of the lowest cost producers in the world ($190) and RMS cheapest in AUS ($300). Neither have debt and have sound management, but do have different characteristics which is why I hold both. I intend to keep positions in each through this period for however it takes to sort it all out.

      Hope this helps.

  5. fred
    :

    Thanks Ron and Sav for your views on CMI Limited ( cmi ) I am not overly concerned about my position in ( cmi ) Roger your view would be very interesting !!!!!!!!

    Thanks

    • Andrew
      :

      Loosley speaking yes. Stars will eventually turn into cash cows as they mature and the market growth declines. According to the theory you want a good mixture of both stars and cash cows however and maybe the odd question mark which could be turned into a star.

      Google “BCG Matrix” if you want to hear more about it.

    • Ash Little
      :

      Star use up more cash than cash cow because they grow more rapidly,

      Think MCE and VOC as compared to WOW or maybe now JBH

      Andrew is not a total fan but I like these 4 groups.

      TLS is the dog (Think declining fixed line) and the data centre start up is the question mark.

      Nothing wrong with cash cows at the right price but they are second prize. First prize is stars at a big discount

      • Andrew
        :

        Hi Ash,

        I do believe that the groups are helpful, my problem is the mthod they use to come up with to decide where the business or SBU falls. It places too much emphasis on market share.

        The groups i agree are great, and i have used a variance of this and others as part of my analysis and quality score (albeit a very tiny weighting). I think that and its GE evolved model are both still a bit simplistic.

        I use them but not in the exact way they were intended. Kind of the same i do with Rogers book, i’m a bit annoying like that, i tend to want to innovate to suit my needs and tinker with stuff until i’m happy. I’m sure Rpger won’t mind a si believe he has the same type of view and has done it to come up with his investing system.

        I think they do help you get your head around what to expect from the company. i.e that a cash cow would likely to be a mature company so you can expect ROE to level off or decline whilst pay out ratio goes up. Profit growth tends to be more relating to increased operating efficiencies as growth opportunitys decline.

        I look for “stars” with a big identifyable competitive advantage that is trading at a big discount to IV, i will however also look for cash cows. Happy to pass on question marks till they decide which way they want to go

      • Ash Little
        :

        Nice Andrew,

        That is a similiar way to how think of it.

        You must be absolutely aceing your degree at the moment

      • Andrew
        :

        Hi Jim,

        Sorry thought i would add more to what i said about this in case you were interested. The BCG model that breaks companys down to 4 categories states that a company wants to have a good mix of stars and cash cows. There is then some strategies determined for management to follow based on which quadrant they fall into.

        The reason they say to have a good mix of stars and cash cows is that you need to invest into the stars and to do this you can harvest the money from the cash cow.

        TO put this into an investing point of view, you can harvest the dividends from WOW and invest into VOC. WOW is a mature company with little growth but VOC has huge growth potential and will need money to be invested into it to help it grow. So to do this you can take the money being spewed out by WOW as their growth has slowed or stopped and are there for paying more dividends out to shareholders rather than retaining it.

        Its really something more for making management decisions and not for investors but as Ash says the categories are useful and you can use these categorys to loosley class companys you analyse with a little bit of creativity.

        I have kind of merged this witht he product life cycle, i then use this to help get a picture of what the company will look like and what it will need in the future. It has helped me determine a form of risk in the company.

  7. Grant Duggan
    :

    Roger would you mind giving me the MQR on a business MTU i have looked at this one for a while now,most of their criteria appear to be in the right area for me.However i am looking for a larger MOS and as long as i stick to buying quality my success will continue.My overall priority before investing is to get some idea where and how this company rates.
    I have read some blogs about this company in earlier posts,but have not picked up on where they rank.Thanks Roger and room for all contributions,maybe one day someone might need to know about laying bricks,then i will be able to contribute with knowledge.Until then i will keep learning about value investing,and loving it.

    • Ash Little
      :

      Hi Grant,

      Not Roger but i am certain it would be an A1 or A2.

      Definately investment grade

    • Peter M (Mully)
      :

      Hi Grant,
      I have this stock rated as an A1. Hope this helps but it’s just my layman’s opinion and not advice of any kind.

  8. jerry
    :

    hi guys & girls,
    had a look at COU (count financial) ROE of approx 40% + nice dividends. any thoughts on the company?

    • James
      :

      Unfortunately the coming Bill Shorten reforms to financial planning trail income will cruel future cashflows, therefore cou is one I’ll pass on unless the Libs gain power before legislation passes.

    • Andrew
      :

      That could be the best thing for everyone on this forum Ann. Just remember not to get too caught up in where the market is going. If you want to buy those businesses you have always been waiting for but are expensive than you need the market to turn south for a little bit. Than we can all get excited and go on a shopping spree.

      Its important you don’t get too focused on where the market is heading, it will send you crazy and despite what they say, no-one can accuratley predict the markets or share price direction. Read Rogers newest post, Mr Market has some pretty severe emotional problems.

      If i got worried about where the market was heading i wouldn’t have been able to by CBA at $26.00.

  12. Harry L
    :

    Hi Roger:

    Just wondering where we sit with WAN and LEI in light of recent events.

    I have IV on both down significantly due to capital raisings. Does this fit with your view?

    I guess it is too early to speculate on the potential for each of these Blue Chips to recover in the short term. Do you agree?
    Further to the above, I just managed to bail out of MND during its recent downturn. Is this a case of the market weighing the value of a stock.
    We bought under $12.00. Which was below IV at the time, and preserved profits which were significantly above that. Now its heading up again. What is going on?

    Comments from all appreciatted

    Best Regards

    H

      • Harry L
        :

        Hi Roger:

        Price guides me relative to IV & MOS and the cost of a lost opportunity.

        Great work and many thanks.

        Still learning.

        H

    • Stephen
      :

      Hi Harry,

      Like you I am a holder of MND. My buy in price was $13.50 and like you I’ve been churning thoughts on whether to sell down and take some profit. My IV for 2010 was about $14.80 and est IV for 2011 about $17.30 or thereabouts. I believe my IV for 2011 is higher than Rogers. So, MND has been trading somewhat above its IV which is one of the reasons to perhaps consider selling out. I have decided not to for the following reasons:

      I’m a long term investor with a long time line in front of me.

      I believe that the share price of MND is currently above its IV and probably somewhere around it’s 2013 value.

      I believe that MND will continue to grow its EPS and that in 2013 it will be just as good a business as it is today.

      I believe that the current sell down is profit taking only and that MND is an excellent business whose business model is still intact and profitable.

      Despite the recent listing of a number of new engineering businesses, MND enjoys a brand advantage through its delivery of top class business outcomes that will ensure it continues to stay ahead of the newer companies.

      I have therefore decided to ignore the current price action and keep my entire holding. Having said that there would be a price point at which time it would be just to tempting not to sell the stock down but for me that would happen if the share price starting to reflect IV that wasn’t going to be seen by the company for the next 5 or so years.

      Hope this helps

      Stephen

      • Harry L
        :

        Hi Stephen:

        Thanks for the response.
        Like you we have no doubts regarding the quality of the business. We did feel it was running well in excess of its 2011 IV and were unsureif the market weighing machine may pull it back to its current IV or push it to future IV. For us, with a significant profit on the table, a dividend equal to or a little less than back interest, we thought it safer to take the profits and drop the funds into a bank account to wait the next opportunity(which may be MND again) for info I have MND 2011 IV @11%RR $12.04 to $14.43, 2012 IV @ 11%RR $13.33 to $17.89, 2013 IV @ 11%RR $15.25 to $18.46.

        Thanks again

        H

  13. Raymond
    :

    Roger,

    I too have Fosters and were daunted by the number of pages. I will retrieve the demerger booklet and will try and find that pro forma balance sheet. I have owned fosters since CUB days and believe for years that it has been a cash cow that has become a steer.

    I am looking forward to finding and hopefully making sense of the accounts.

    Raymond

    • Ash Little
      :

      Hi Raymond and all,

      Someone much smarter than me put companies into 4 categories,

      Cash cows, stars, dogs and question marks.

      There is also a cycle to this which I like.

      To me fosters is a barker rather than a milker,

      Just my View

      • Andrew
        :

        That would be the chappies at the Boston Consulting Group.

        Have to say i think the method they use to be a tiny bit flawed but helpful none the less.

        Fosters should have just focused on running the beer business and trying to run that as well as possible. They have some great brands. Instead, they wanted to get into wine.

      • Andrew
        :

        Adding more to this, doing a very unscientific process. if you assume that Fosters has a high market share (which i believe it does in at least the beer dept) and that the bevarage market is a low growth market which i think is also as bit correct than Raymond is correct and it is a cash cow.

        Kind of re-inforces why i think the BCG model is useful but overall flawed as i am not sure how much cash they are bringing in.

  14. fred
    :

    Hi Roger,

    Could you put CMI limited ( cmi )on your list to look at for me please ( cmi ) had an announcement on Wednesday 27/04/2011. What would you make from this and yes I do have a small holding in ( cmi ) I did speak to Troy Harry from Trojan ( tjn )and Troy said that the drive was that ( cmi ) was not paying dividends among a couple of other things.

    Thanks Roger always

  15. Nick
    :

    Grant, try these (they’re before any nasty-supposed- ‘abnormals’)

    FY11 EPS 7.8c DPS 4.6c
    FY12 EPS 8.8c DPS 5.0c
    FY13 EPS11.6c DPS6.5c

  16. Simon Anthony
    :

    I have Foster’s Group Limited Demerger Booklet sitting on my coffee table. It’s not a prospectus, but the demerger of Treasury Wine Estates Limited by Foster’s is anything but straightforward. 190 pages of financing,risk management and capital commitments of two companies to get your head around! Twice the fun for the value investor!

  17. darrin
    :

    HI Roger

    Thankyou for going through what is the most important part of the prospectus to look at.

    What is your percentage for a big discount to IV?

    cheers

    darrin

  18. Grant Duggan
    :

    Just read the latest TSM annual report,was hoping someone could help me out with forecast EPS andDPS figures.I dont have access to these figures using bell direct or e-trade.I for one have to say i have had a little trouble taking much positives from this report,but have not give up on them just yet.
    Would like to no if anyone has any relevant feedback on the stores in the UK.Thanks to all again for your help and contributions.

    • Greg Mc
      :

      G’day Grant,
      One of the things that I didn’t like was that TSM raised $16m through a share issue then almost immediately declared a partially franked (45%) dividend worth $4.5m. Surely they’re not deliberately trying to hurt their shareholders? It was one of the reasons I sold them.

      • Craig
        :

        Hi Greg, Grant, Roger,

        Roger, I would love to hear your thoughts on this. I have seen many companies on the ASX raise funds and paying dividends in the same year. This does not appear to show good capital allocation skills. But contrary to this I was very impressed with the CEOs interview on Switzer where he spoke about growth using cashflow and not debt, running a simple and understandable business model, and generally appeared to have shareholders interests at heart.

        I am sure it is difficult to find the time with your undoubtedly hectic schedule to personally answer all questions on this blog, but It would be so very much appreciated if you could give us your thoughts on this issue with relation to TSM and other businesses that raise funds and pay dividends that might otherwise appear to be solid businesses with high rates of return on capital. I am sure others would also be eager for your thoughts on this subject!

        Thanks in advance,

        Craig

      • Roger Montgomery
        :

        Hi Craig,

        Quite simply I understand that franking credits have no value in the company and enormous value to Australia’s ageing population of investors. But I would prefer they didn’t. Franked or unfranked, share prices would be higher if high ROE companies, didn’t dilute and could continue to retain profits and re-employ at high rates of return rather than pay dividends.

      • Craig
        :

        Thanks very much Roger, much appreciated. Your making sense as usual. While it’s not ideal, subjectively it should not be a deal breaker – as many good businesses appear to dilute while paying dividends, and to exclude them simply on their dividend policy would mean missing out large gains, even if the efficiency of their capital management is absolutely perfect.

        I would guess this would the sort of thing an active shareholder with access to management would be trying to influence?

      • Peter M (Mully)
        :

        Hi Craig,

        Unfortunately, it’s not unusual to find that the Board and/or senior executive of a company are not quite as adept at managing its capital as they are at managing its operations and other aspects of the business.

        Another recent example was MCE (a favourite on this blog) and it’s recent decision to pay a dividend and then undertake a quite substantial capital raising.

        Roger could probably make a living advising these companies on their capital management strategies amongst other things. (Perhaps we should consider voting our collective shareholdings in these companies to getting Roger a seat on their Boards :))

        Whilst not a deal breaker for me at this stage, I hope that these two companies realise the folly of their ways and adopt a more responsible approach towards their capital management strategies in the future.

      • Gavin
        :

        I tend to disagree with the retain v’s growth argument. The thinking may be correct for USA tax situation but not Aus.

        Given Australian taxation laws and number of shareholdings held through superannuation. It is likely that the aggregate shareholder tax rate for distributions is less than the corporate tax rate. If that is the case than so long as transaction costs don’t make it prohibitive, the logical course of action would be to pay out all profits to the extent that they are fully franked and raise new capital at the time it is required by way of a RENOUNCABLE RIGHTS ISSUE.

        If you fully owned a company this is exactly what you would do where your tax rate was lower for distributed profit than retained profit. When your fully owned company had the ability to advantageously deploy capital at a high rate of return you would re-contribute the funds as needed. You certainly wouldn’t freely pass that opportunity to others. However this is what management does to existing shareholders when they raise capital via a SPP instead of a rights issue.

        What’s important in capital management between company and shareholder is that the shareholders interests are maximised and that they don’t get unilaterally diluted by the company on an ownership percentage basis. The concern over the difference between ROE and return from a capital raisings is misplaced. The irrelevance becomes apparent when you consider a company dealing with a single owner.

        If management doesn’t use rights issues for new capital requirements than it would probably be better that they retain the capital as otherwise you will be diluted out of the advantages of future high growth opportunities. This is sadly very ironic – and good indication to have a hard think about agency risk and the premium you are prepared to pay for growth opportunities.

      • Roger Montgomery
        :

        Hi Gavin,

        Thank’s for sharing your thoughts. It is good to have a variety of views. You are right for a low ROE company Gavin. With a simple table, I can demonstrate however that even after franking is taken into account, a company with a high rate of return on equity is better off retaining and compounding (it will produce a return for the investors that is equal to the ROE) rather than paying out fully franked dividends. If you are investing in Super and/or holding for longer than a year – you are much better off.

      • Gavin
        :

        Roger

        I disagree.

        Even a high ROE companies with ample growth opportunities should distribute its profits to the extent of the franking account balance and re-raise new funds with the following caveats.

        1) Shareholders aggregate tax rate on dividends received is less than the corporate tax rate.
        2) costs of distributing and re-raising funds don’t outweigh the tax differential advantage
        3)Existing share holder’s growth opportunities aren’t diluted on a percentage ownership basis through the re-raising of new funds.(ie renounceable rights issues are used)
        .

        I’m happy to have the debate if you want to put up the table you refer too.

      • Ash Little
        :

        Hi Gavin,

        The flaw in your argument is that when profits are reinvested no new shares issued.

        A capital raising involved issuing more shares and if the company is an A1 the issue will be way above existing EQPS.

        I suggest you model your theory over a 10 year period using a constant PE (Swear Jar) of say 12 with two identical companies both with a ROE of 20% one with a payout ratio of 100% fully franked dividend then raising capital to replace the dividend. The second company retain 100% of the profits.
        Please assume that company A makes the exact same profit company B. Company B’s Profit is easy to calculate as it will be a constant 20% ROE. In this scenario company A should have declining ROE
        The results should surprise you. If they don’t I would respectfully request you submit your model for critical appraisal.

      • Vinny
        :

        Thanks for your views Gavin!

        I am only an infrequent stroller on the blog, but thought I would add my 2c.

        From what I recall approx.1/3rd of Equity in local markets is owned by foreign investors. These could be either controlling interests (at least >10%) or portfolio holdings that are less than 10%. Tax law changes that brought about imputation only mildly disadvantaged entities with controlling interests, but as for majority of holdings were at par due to cross-border tax laws and rebates with regard to withholding Tax.

        The whole point of me mentioning this is there have been multitude of studies attempting to attach value to the franking of dividends per se and have relied on crude methods such as ex-dividend price movements, but IMHO it is a futile exercise as we are trying to price rationality which is not a mechanical trait.

        So on balance as to capital allocation and issuance, even corporate financier’s have to take a balanced approach as to the ultimate benefit they see in the distributions to ultimate investors. It cannot be considered an isolated case of local retail investor or a tax-advantaged super fund’ interests.

        As to the wider debate, I side with roger that business economics hold more relevance ie ROE or ROIC. Retention or payout ratios should always be a function of future business prospects.

      • Matthew R
        :

        Hi Gavin – EQPS

        If you own the whole company then I agree with you, but if you own only a portion of it and are taking up shares above EQPS i think your idea may not hold true

        Interesting ideas and a good discussion

      • Gavin
        :

        Vinney, Mathew, Ashley

        Thanks for engaging in this discussion.

        Ashley – Why would company A have reducing ROE? It is simply replacing its dividend distributions with newly raised capital. What it would have is escalating shares on issue.

        If the company has a $1 profit (NPAT) and it pays it all out, the position of a tax advantaged shareholder – say a super fund in pension phase with a tax rate of zero, then you receive a grossed up dividend of $1.428… The company then raises $1 in new capital from you to replace the $1 distributed through dividend. The company is square and you are better off by your tax advantage.

        Vinny’s point about the difficulty in knowing the makeup of your shareholder base and their tax position is valid. Though I would take the standpoint that without evidence otherwise your shareholders in aggregate are tax advantaged. Super tax advantages in my opinion outweigh private holder tax disadvantage especially given the opportunity for those private holders to use structures to reduce their tax rate to at least the corporate level. Inter-corporate are all neutral. Foreign holder’s position????

        Now the question of escalating shares.

        The best way to get your head around this is to think it trough from the view point of being the single holder. It doesn’t matter how many shares are on issue as you will own them all. The point that drives your wealth is how the return achieved on the new capital not the accounting mechanism for how many shares are on issue. If rights issues are used so that your % ownership is not changed through the capital raising then your position as a minority holder is no different to the wholly owned example.

        Its only when % ownership dilution occurs that the price of the capital raising comes into play. Here the point is exactly the same as for buybacks. EQPS has nothing to do with it. Whether price is above or below intrinsic value has everything to do with it. If the company raises capital at below intrinsic value, existing shareholders will have a wealth transfer from them to new shareholders. If the capital raising is priced above intrinsic value then existing shareholders will have a wealth transfer to them from new shareholders. (If you are both the existing and new share holder you are on both sides of the equation hence the irrelevance of the price when % ownership does not change)

      • Ash Little
        :

        Hi Gavin,

        Company A & B have 100 Shares and eqps of $1 and a ROE of 20% therefore EPS of 20C

        PE of 12 therefore share price is $2.40

        Year 2 company A has 108 Share and earnings of $24 Thereos EPS is 22c and ROE is 18% becuase equity is now $120.

        Company B has $120 in equity with 100 shares therfore EPS is $24 and ROE is 20%.

        Share price year 2
        Company A =$2.64
        Comapny B = $2.88
        Market cap Company A $285
        Market Cap Company B $288

        Year 3
        Company A’s ROE drops to about 17% while company B,s ROE remains at 20%

        Keeping going for 10 Years and compare your results. You should be suprised. I know because I have done the maths because a few years ago I once thought like you do but figures do not support this type of capital allocation

      • Gavin
        :

        Hi Ashley

        Difference between companies A & B at year 2 is: that Company A has $120 in contributed Capital whilst company B has $100 in contributed capital and $20 in retained earnings. Both have $120 in equity. Total equity will be the same every year, only the ratio of contributed equity to retained earnings will change.

        Given that companies A&B are identical apart from their payout policy and their total equity stays the same then their return on equity must stay the same.

        EPS does decrease as more shares are issued via the capital raising. From the shareholders point of view this is compensated by the fact they own more shares.

        In your example for company A year 2:

        I agree that EPS are 22cents but 22 cents times 108 shares = $24 earnings divided by the equity of $ 120 = ROE of 20%. I’m actually at a loss why you get it to be 18%. I assume you are incorrectly multiplying the 22cents by 100 shares not the 108.

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