Author: Gus Wilkinson

A major topic of debate within Corporate Finance, the capital structure of a company refers to how they are able to finance anything that they do. Whether it be through debt or equity, the argument surrounds the pursuit for an ‘optimum’ capital structure, which would enable a company to fulfil financial goals whilst not taking on a huge amount of risk. This article will look at capital structure explaining its importance, current market trends and why it is so difficult to find this ‘optimum’ solution. 

What is capital structure?       

The capital structure of a company is all about how they finance their operations and growth opportunities. Made up of a combination of debt and equity, a company’s capital structure is integral to its success because it is what enables the firm to strive towards their economic goals, and pay their bills.
Debt has been used by companies for hundreds of years to finance a whole array of various avenues. A company’s debt is borrowed money being used in the business that at some point needs to be paid back. This debt generally comes in the form of loans or bonds, with most major companies using both forms. Though they are similar, there are some distinct differences between the two. With a loan, the company receives money from a creditor (usually a financial institution or an entity with sufficient spare capital) and agrees to pay interest on the loan on top of regular repayments back to the creditor. Bonds on the other hand are debt instruments sold by the company themselves to raise capital. Governments and investors purchase these bonds in return for a steady stream of payments over the bond’s ‘lifetime’ before receiving back their original payment at the end. The major difference however is that loans are usually non-tradeable meanwhile bonds can be traded on a market meaning their value can rise and fall. 

Equity refers to financing through the sale of stocks and shares. In choosing equity via issuing shares as method of finance, companies will have their shares listed on a stock exchange to be traded. Equity also covers retained earnings, which are previous amounts of money taken from profits which have been kept to finance future operations.

Why is the capital structure of a company important?

As previously mentioned, capital structure is one of the most important parts of a company’s success for multiple reasons. Firstly, it influences the return a company earns for its shareholders. If a company chooses to issue more shares and profit levels are maintained, the earnings-per-share (EPS, calculated by dividing income by the number of shares) would decrease because the same income is being divided up among more shares. This is an important consideration to be made because EPS is a popular metric used by investors to see if a share is worth purchasing or not. Therefore, by decreasing the EPS, a company could potentially seem less attractive to an investor which is the opposite of what a company wants.
Additionally, the capital structure of a company is a key point of analysis to see how a company would perform in the event of a market downturn or a recession. A company laden with debt is likely to struggle in the event of a downturn because sales may stall, meaning there is less cash flowing into the company and so paying creditors is more difficult. Consequently, bankruptcy may end up a more likely possibility. Similarly, an equity-heavy company struggling as a result of market conditions is also likely to experience uncertainty where shareholders are pulling out of the market, decreasing the overall level of investment in the company. Without sufficient investment, the company may struggle to meet its day-to-day costs (let alone finance future growth opportunities) which could lead to the gradual demise of the company.

Current Trends in Capital Structure

In order to look at the current trends in Capital Structure, we are best positioned to look at the bond and equity markets to gauge market sentiment. In a year unforeseen by all, the structure of companies has never been so important.

So far in 2020, the bond markets have been flooded with new debt. The COVID-19 pandemic has led to an overhaul in government stimulus packages as they looked to prop up the economy and financial markets. $525B worth of new debt has been created in Europe whilst new debt deals in the US have topped $1.2T [1]. This sends a clear message to the market that companies are looking to have sufficient cash on hand to fuel business and also to ‘ride the wave’ that the pandemic has caused in the global economy. The pandemic may have also led to an increase in bond values as falling dividends for some firms have meant investors look for alternate avenues of consistent income.

With bond markets flourishing, the fortunes of the equity markets are also beginning to turn. Despite market hysteria wreaking havoc earlier on in the year, 477 IPOs went ahead in Q3 topping the number of IPOs in Q1 and Q2 combined. Evidencing a clear desire of some firms to still go to market, the level of share offerings looks to continue into Q4 though the dark clouds of the US election and the possibilities of more lockdowns potentially put this scenario in jeopardy. [2]      

Is there an ‘optimum’ capital structure?

Evidently, the COVID-19 pandemic has led to changes in the capital structure of many firms. Over the past hundred years or so, there has been a huge topic of debate over whether or not there is an ‘optimum’ capital structure that a company should take in order to achieve the most they can, whilst also taking on as least risk as possible. Whilst many academics have seemingly found this equilibrium (where a firm’s Weighted Average Cost of Capital, aka WACC, is minimised), the consensus remains that it is up to financial managers and strategists to make such a decision. This is mainly due to the drawbacks of debt and equity that are sometimes ignored in these models made by academics. Debt may be easier to obtain than equity but also has colossal costs involved in the event of a loan default or bankruptcy. Likewise, the cost of issuing equity can be enormous with the average cost of an IPO coming between $8.2M and $25M, making obtaining equity harder. [3] With that said, the hunt for an ‘optimum’ capital structure will continue though, in the modern day, it seems like it is up to the discretion of managers to decide how debt and equity make up their company. 

In summary of such a vast topic, the capital structure of a company is one of the most pivotal decisions that can be made by financial managers. As seen over the past year, the state of the global economy and market conditions can change at any time and so it is ever-more important that a balance is made between debt and equity which permits success in the biggest way possible whilst limiting the effect of crises.

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Gus Wilkinson

Undergraduate at the University of Leeds studying Banking and Finance

From the retail investors to commercial banks, dividends are an important part of financial markets. These payments to shareholders, often dubbed as ‘rewards’, are not only a topic of debate between financial managers but are also an important component of equity valuation. This article will investigate the reasons for and against dividends, whilst also delving deep into the current state of the dividend market and the famous Dividend Growth Model.

What are they?

A fundamental part of the stock market, a dividend is a share of profits and retained earnings that a company pays out to shareholders, usually quarterly. Dividends are issued on a per-share basis meaning that for every share owned, a set amount will be paid to the owners of said share. They are most commonly issued in the form of cash or stocks wherein instead of a monetary payment, the payment is made in the form of additional shares. One-off dividends (known as Special Dividends) may also occur but are rarer and are as a consequence of better than expected performance or supplementary cash within a company. 

An important term to note is Dividend Yield. The yield of a dividend is the percentage of the share value that is being paid out to shareholders, calculated by dividing the dividend issued per share by the current share price. Generally, the higher the yield the better although it is important to evaluate whether the company offering the high yield is also reinvesting in themselves.  

A Brief History

The first recorded dividend was issued by the East India Company for almost 200 years in the 17^th and 18^th centuries, at a yield of around 18%. [1] In the 19^th and 20^th centuries, yields averaged around 5% but market sentiment changed in the 1980s. With the perception of risk disappearing along with the bear market, investors looked at equity less as an income stream, and more of a way to appreciate the value of their money and with that went dividend yields. However, the Tech Crash of 2000 and the Financial Crisis of 2008 pushed risk back again to the forefront of investors’ minds. Record dividend payments of £110.5bn in 2019 show more of a focus on rewarding shareholders in this way. [2] [3]

COVID-19’s Impact

Like with most of the financial world, the COVID-19 pandemic has had grave consequences on the profits of many firms, impacting the payment of dividend. Companies such as Shell have cut their dividend for the first time since World War Two as a result of a 46% fall in net income in Q1 of 2020.[4] Telecommunications company BT have also felt the brunt of the pandemic, suspending their annual dividend for the first time in 36 years – a clear signal of financial worry. [5]Findings suggest although they are rarer, dividend bear markets last longer than bearish stock markets, spelling worry for dividend investors looking for returns on their investments any time soon. [6] 

The Dividend Aristocrats

Though the recent history of dividends points towards a slowdown of such payments, there are some firms that have kept up payments to shareholders for extensive periods of time. The term ‘Dividend Aristocrat’ refers to a list of companies within the S&P 500 (an equity index of some of America’s largest companies) who have paid and increased their base dividend every year for at least 25 consecutive years. Typically, the companies listed, which totalled 66 in July 2020, are proven companies in their sector with great financial management and reliable income. The likes of Coca Cola and Johnson & Johnson sit at the top of the list having increased and paid dividends for 57 years making them very attractive to dividend investors. [7]    

Why Give Out Dividends?

A common topic of debate in financial management is whether or not a company should issue dividends. Sceptics would argue that if investors want a steady stream of payments, they should invest in bonds. Additionally, many companies view their profits and retained earnings as a way to finance future growth which, in the long term, would increase the value of the company’s shares to the benefit of the shareholder. Elon Musk’s Tesla is a notorious company in favour of financing future growth as oppose to issuing dividends, who ‘do not anticipate paying any cash dividends in the foreseeable future’. [8]

The main argument in favour of paying dividends is that it provides certainty of a company’s financial health and stability within a company. This incentivises long-term investment so investors can reap the rewards of the dividend payments. The investment enables the company to fund new projects and thus fulfil the goal to grow as a business.  

The Dividend Growth Model

Whilst there is much debate about dividends themselves, them being issued by a company holds great importance for investors and financial strategists who look to incorporate these payments into equity valuations. The Dividend Growth Model is a piece of financial analysis used daily to work out what equities to buy and sell to optimize portfolio returns. This is done by estimating the fair value per share of equity, comparing it to the current share price and then evaluating whether the equity is undervalued or overvalued. The model is as follows:

Where:

P = the fair value per share of equity

D₁ = the dividend paid

k = the required rate of return (the minimum return investors require to buy the equity)

g = expected dividend growth rate

The reality of the Dividend Growth Model is that it is simple, meaning that whilst it can be a fast way to get indications of an equity’s value it does have some shortcomings. Firstly, the model assumes a constant growth of dividends for an extensive time period which, in reality, can be difficult to predict. This means that the calculations must be frequently repeated to ensure accuracy. Furthermore, the model does not take into account pivotal parts of a share’s value such as brand loyalty or ownership of intangible assets (patents, trademarks, copyrights etc.) which increase the value of shares. Finally, there is no regard for market conditions which undoubtedly would have a significant impact on share value.
Whilst its shortcomings are prevalent, it is the simplicity of the model which makes it so useful to investors. Like all pieces of financial analysis, the model should not be used in isolation and should rather be utilised in combination with various other valuation techniques, leading to a more accurate final calculation. Overall, the model goes to show the importance of dividends in the daily equity valuations that occur across the financial world.

In summary, Dividends are a pivotal part of the global equity markets for all investors. Whilst there are many cynics, dividends will remain an integral part of the financial markets for firms wanting to boast financial health and attract long-term investment. Meanwhile it will be interesting to see if the COVID-19 pandemic continues to affect dividend payments, or will firms return to the ‘shareholder friendly’ years of recent history.  

Gus Wilkinson

Undergraduate at the University of Leeds studying Banking and Finance

Widely known for it being Warren Buffett’s choice of strategy, Fundamental Analysis (FA) is a form of investment analysis used every day by investors all over the world. FA can be used on all forms of securities however is most popular amongst stock traders. This article will investigate the principals of this type of analysis before commenting on the drawbacks of such a strategy.       

An Introduction

The process of FA is to evaluate a security’s intrinsic value by examining related economic and financial factors. The intrinsic value (also known as a ‘real’ or ‘fair market’ value) refers to the perceived value of a security based on future cash flows or, put more simply, the price a rational investor is willing to pay for an investment. 

The aim of this type of analysis is to then compare the current market price to the calculated intrinsic value to see whether the security is undervalued or overvalued. A security would be considered undervalued if the intrinsic value is higher than the current market price. Meanwhile to be considered overvalued, the intrinsic value would have to be lower than the current market price.

FA works in a macro to micro perspective, meaning that overall economic conditions as well as the conditions of the individual market and/or firm must be considered in its valuation. Consequently, there are many factors that could alter the intrinsic value of a security.

Quantitative or Qualitative

The methods used within FA can be categorised into two groups. Firstly, there is Quantitative FA. This looks at the hard numbers and financial metrics of a firm, making companies’ financial statements extremely useful to the investor. With this information, investors look to gage companies’ economic prospects and do so using a range of key-performance indices.

Qualitative FA focusses on the less tangible, harder to quantify side of a business and is more subjective. The list of what this encompasses is practically endless, but some examples would include management quality, brand notoriety or current fashions and trends. Tesla is an example of a company that, during a Qualitative FA assessment, may have their intrinsic value increased. The global notoriety of their CEO, Elon Musk, as well as the growing popularity of electric vehicles cannot be ignored when evaluating the car manufacturer due to the impact these characteristics have on the markets, which potentially is not apparent in their financial data.  

The combination of both Quantitative and Qualitative analysis is required for a more realistic calculation for the security’s intrinsic value.

Key Financial Metrics

FA is subjective and different investors can have different opinions on the same security. With that said, there are some staple financial metrics and indices acting as some of the most important quantitative indicators.

Earnings per share (EPS) is an extremely useful financial metric calculated as a company’s profit divided by the number of outstanding shares. EPS indicates how much money a company generates per share and so is an important metric for investors looking at the profitability of a company. The higher the EPS, the more attractive the investment should be as it indicates higher profit levels.

The Price-to-Earnings (P/E) ratio is a metric used to determine the market value of a stock compared to its earnings. Essentially, it is used to show what the market is willing to pay today for the stock based on past and future earnings. A high P/E ratio can be perceived as either overvalued, or an indication that the market expects high growth rates in the future. Conversely, a low P/E ratio is a suggestion of an undervalued stock, or a stock that the market does not have high hopes for. The P/E ratio is of specific interest to investors as it standardizes stocks of different prices and earnings levels, making it a great metric for comparison.

Return on Equity (ROE) is a calculation used to determine the efficiency of a company when using the equity of shareholders. Shareholder equity (the net worth of a company) divided by the company’s income gives a percentage figure of how well the company is using the shareholder equity to create income. Therefore, the higher the ROE figure, the more efficient the company and thus potentially more attractive to investors.

The Debt-Equity (D/E) ratio is a metric used to evaluate a company’s financial leverage (how much of their operations are financed by debt). It is calculated by dividing the total liabilities of a company by their shareholder equity (both which can be found in a company’s financial statements) and reflects the shareholders’ ability to cover the company’s debts in the event of a downturn. A high D/E ratio could therefore be considered less attractive to investors as, in the event of a downturn, they may be expected to use their money to pay off the debts. Although it can vary per industry, the general consensus is that a D/E ratio should not exceed two.

Discussed above are only a few of the hundreds of different metrics used every day by investors to make financial decisions. The successful use of FA is about utilising these metrics together and not exclusively. The combination of the use of metrics paints a much clearer picture than the use of just one or two, enabling greater returns.

The Drawbacks of Fundamental Analysis

Whether it be Fundamental or Technical or even artificial-intelligence-based, the most successful of investors use a combination of various types of investment analysis. That being said, there are certainly some drawbacks of FA that lead investors to choose different equilibria of investment analysis methods.

Most notably, FA is time consuming as it requires each investment decision to be considered in minute detail. Consequently, this type of analysis, when used on its own, is ultimately for mid to long-term investors.
Making investment decisions using FA also limits the information you receive about short term market conditions. Whilst you may find out about a company’s current financial health, short term price volatility cannot be forecast from the financial statements output by the company. This is evidence as to why it is necessary for investors looking at the short, mid and long-term to use a combination of techniques.

Another drawback of FA is that it requires investors to take everything at face value whilst there can be, and have been, scenarios where the information found in companies’ financial information is falsified or misrepresented. For example, the Wirecard accountancy scandal in June 2020 revealed a €1.9billion hole in their finances. [1] Following the reveal of the scandal, the FinTech company’s shares fell by 75% leaving once hopeful investors at a loss. [2] Whilst arguably nothing could have been done for the investors who believed the information Wirecard produced, it is certainly something that all would have wanted to avoid.

To summarise, Fundamental Analysis is a hugely popular and vast method of valuing prospective investments and it is possible to amass great success doing so. Whilst new analysis strategies (such as Artificial Intelligence) are gaining traction in the financial world, FA will continue to be used by investors across the world due to its proven track record.

Gus Wilkinson

Undergraduate at the University of Leeds studying Banking and Finance