Hi everyone, I’ve got a quick question on tying equity material from Level II to real world markets. A constant theme we see in Level II is that if a company has profitable projects (ROE > WACC) then it should increase its retention rate in order to undertake those projects, but if it does not (WACC > ROE) then it should increase its dividends. Does this only apply to, say, manufactering or “non human-capital intensive” firms? What I mean is, in today’s market you hear companies, ranging from financial to industrial to all sectors of the economy, cutting dividends, but obviously this is not a good sign or a sign that they have “profitable projects.” Also, there’s a part in the Level II material, I forgot where, that talks about how in the U.S. (vs. Japan) cutting dividends is a very negative sign to investors. So can anyone clarify on the contradiction between high retention rate signaling good opportunities within the firm but the implication that dividend cuts/low dividend yields being bad signs? Thanks.
Retaining assets for growth opportunities can be a good thing, lets say you use that capital to gain market share, expand, whatever. Retaining assets to rebuild your capital or to hoard cash because credit is cruddy, you arent sure how your cashflow will be in the near term, and you are trying to survive, that is a bad sign. It is not just a bad sign however, in that investors see you do it and may think you are taking steps necessary to make sure you are around in a year, which would then be a positive sign rather than paying that money out and then going bankrupt in a year and the share price goes to zippo.
so what you mean is it also matters HOW the retained earnings/dividend cuts are used? if the company uses the excess capital on r&d or new projects that is a good sign but cutting dividends to hoard cash/raise capital like the banks are doing now is bad? i know thats simplistic but am i on the reight track?
you are on the right track. “if the company uses the excess capital on r&d or new projects that is a good sign” Sometimes, as long as those projects are good projects. “but cutting dividends to hoard cash/raise capital like the banks are doing now is bad?” Sometimes, as an investor I like dividends cuz they pay me money. I like to get money. So when a company stops paying them, that sucks, thats bad. But for the company, that means they have extra money leftover instead of paying me, so they can use it for other stuff, and that can be good for them. The banks, for example, need their cash to stay in business (generalization and simplification, but for sake of example). So them keeping the money instead of paying it to me is a good thing, cuz we want them to be around in a year or two…