Executive Summary
The dividends are off the pace
Their value is below their face
So our models we must bend
Towards the valuation end
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When the market and face valuation of dividends differ, the valuation models used for valuing shares and selecting investment projects are likely to result in valuation errors.
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Where valuations are undertaken across different tax jurisdictions, different valuation models may be required.
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Where adjustments are made to discount rates rather than cash flows, this increases the likelihood of error.
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All these problems can be resolved by a simple modification of the standard valuation models.
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The approach, called the q method, provides a convenient and simple valuation model with almost universal application.
Introduction
Suppose that a company declares a cash dividend of $1, then the face value of the dividend is $1. The market value, which is what that dividend trades for in the market, may, or may not, be the same as the face value. Traditional approaches to valuation, such as the discounted dividend model (see “Using Dividend Discount Models”), usually assume that the market value and the face value of dividends are the same. When this is not the case you hit problems in valuation and in making investment decisions using traditional capital budgeting techniques.
A common approach to valuing a share is to discount the expected selling price of the share and then add the discounted value of the dividends that you expect to receive before you sell. This approach is the foundation of the discounted dividend model used to estimate the value of shares. The expected price is by definition a market value, but the dividends are at face value. If the market and face value of dividends differ, adding share prices and dividends together is like adding apples and oranges and calling the total apples. The foundation of the discounted dividend model is therefore decidedly shaky if the market value and face values differ.
Whether the face and market values of dividends differ is a much debated question among finance academics, but there is plenty of evidence that they do. One reason for the difference is taxation. If the company gives you a dollar of dividends and then the government takes away $0.25 in tax, you might well value that dividend at less than a dollar. As it turns out, capital gains taxes also play a role. If instead of paying you $1 of dividends the company keeps that cash in the company, your shares have more asset backing. Consequently your shares are more valuable and you end up paying more gains tax.
The market value of dividends relative to their face value then depends on the relative taxation of dividends and capital gains. In many jurisdictions dividends have a tax disadvantage. This is because returns in the form of price changes are taxed at concessional capital gains tax rates, whereas dividends are taxed as income. In other jurisdictions dividends are tax-advantaged. For example, in imputation tax systems the shareholders receive a refund of corporate tax along with their dividend.
The problem raised by the divergence between the market and face value of dividends also extends to traditional discounted cash flow techniques for capital budgeting (see p. 1099). This is because the use of these techniques is based on their equivalence to the discounted dividend model, as was shown by the Nobel Prize winners Merton Miller and Franco Modigliani.1
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