Principles of Finance
1. Should a firm pay dividends in a year in which it raises external common equity?
2. Discuss the pros and cons of various sources of estimates of future earnings and dividend growth rates for a company
To the extent that “external common equity” includes the purchase of shares of a company’s stock by outside investors, then the answer to the question – “should firm pay dividends in a year in which it raises external common equity” – is yes, it should pay dividends. Dividends are a reflection of a publicly-owned company’s profits, and, unless otherwise noted, for example, through an agreement that profits ordinarily distributed to shareholders would instead be reinvested with the company, are routinely paid out according to the number of shares each investor owns. “External common equity” simply refers to financial resources injected into a company’s operations from outside sources, be they private investors or through securities exchanges. Those financial investments are not made out of charitable considerations, but out of an expectation of a return on those investments, usually in the form of cash. If the revenue is reflected on balance sheets as profit, then it belongs to the shareholders. If it is used for capital improvements, then probably not, unless those improvements result in increased profits. Dividends are profits, so it depends upon how the injection of financial resources is applied; in general, however, external common equity is calculated into profits and distributed in the form of dividends.
While “external common equity” often includes investments by stockholders, however, other external forms of revenue are not calculated as profit. On the contrary, bank loans used for recapitalization or to restructure debt are not profit and are not distributed in the form of dividends; rather, they show up on balance sheets as debt.
When considering the credibility of various sources of estimates regarding the future earnings of a publicly-traded company, the individual investor has historically been somewhat on his or her own. The financial soundness of major corporations, as well as of governments, is usually determined by the three major credit rating agencies, Standard & Poor, Moody’s, and Fitch Group. These “Nationally Recognized Statistical Rating Organizations” (NRSROs) are privately-owned companies that study individual companies, industries, financial instruments, and governments and rate each on the NRSRO’s assessment of their financial soundness. The higher the rating attributed to a company by these agencies, the more financial sound they have determined it to be. The NRSROs, however, are run by human beings (they may use computer analyses in assessing corporate health, but it is still humans at the controls), and humans are inherently fallible. For many years, the ratings these agencies attributed to the corporations and financial instruments they examined carried great weight with investors. That all changed, however, with the financial crisis of 2007-2008, when the NRSROs were found to be haphazardly rating the bundled subprime mortgage loans banks had been issuing without due regard for the ability of loan recipients to repay those loans. That Moody’s and Standard & Poor’s, the two most well-respected such agencies in the world, had failed to properly assess the risk associated with those loans badly damaged the agencies’ credibility.
To the extent that the NRSROs constituted the most reliable sources of accurate information on the financial soundness of corporations yet failed miserably with regard to the subprime mortgage business, knowing where to turn for reliable information is now more than ever dependent upon the individual investor’s due diligence in relying upon other sources of information. Most major financial institutions maintain divisions or departments dedicated to assessing the financial condition of publicly-traded companies, and employ thousands of very smart people for that purpose. A lot of work goes into preparing estimates of future earnings of other companies. Studying balance sheets issued to shareholders is a major component of the process, but so is continuously collecting intelligence on the internal dynamics of companies being studied for signs of imminent management changes, product realignments, mergers, and so on. Again, it is up to the individual investor to study the bona fides of whatever source of information and recommendations one chooses to follow. And, the use of information in determining investment decisions has to be free of “insider information” lest one end up in prison and rendered financially destitute courtesy of the U.S. Department of Justice and Securities and Exchange Commission. The line between legitimate intelligence on a company’s prospective profitability and illegal insider information can be very thin, and one needs to weigh carefully one’s course of action when holding proprietary information on a particular company.