Tuesday, April 14, 2009

Create Your Own Dividend Policy

I've been learning more about the math and mechanics of arbitrage to exploit a mispricing, but only recently begun to understand the power of derivatives in creating specific investment strategies.

For instance, if you liked a regular and steady coupon payment, but had no interest in the other components of a bond, you can go long on a bond with a coupon but short a zero-coupon bond to achieve a coupon strip similar to preferred shares (relatively hedged and insulated from changes in the debt market and interest rates, but yet not quite like equity - more senior).

Although I generally love the idea of creating strategies to manage risk and opportunity (deleveraging, swaps etc) one of my favourites (also simple to explain) is dividends versus EPS. The formula for their relationship is:

Dividends = EPS x (1 - retention ratio)

Note: EPS x retention ratio is often a proxy for equity growth rate - How much money stays with in the company's balance sheet as retained earnings (change or growth in equity).

Now regardless of whether or not a company board decides to approve and issue a dividend based on its operations and cash position, you can create your own "dividend policy".

In the case where a company issues a dividend, but you think they will experience more rapid growth, you can be short the dividend and long the stock (an identical concept to dividend reinvestment). Take the money you receive as a dividend and buy more stock (equity).

In the reverse, where a company doesn't issue a dividend, but you feel like they should, you can be short the stock and long the dividend (begin to liquidate your position for cash). The net effects of each strategy allows you the flexibility to determine and invoke your own virtual dividend policy.

Note that as valuation models, these are all concepts very interrelated to the cost of capital, PE ratios, and dilution as they will effect your fundamental perspective on whether or not you feel dividends should be issued in the first place. This is a fancy way of saying do you think the stock is currently overvalued against it's earnings when you consider it's growth ratio.

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