Chithurst Co gained a stock exchange listing five years ago. At the time of the listing, members of the family who founded the company owned 75% of the shares, but now they only hold just over 50%. The number of shares in issue has remained unchanged since Chithurst Co was listed. Chithurst Co’s directors have continued the policy of paying a constant dividend per share each year which the company had before it was listed. However, investors who are not family members have become increasingly critical of this policy, saying that there is no clear rationale for it. They would prefer to see steady dividend growth, reflecting the increase in profitability of Chithurst Co since its listing.
The finance director of Chithurst Co has provided its board with details of Chithurst Co’s dividends and investment expenditure, compared with two other similar-sized companies in the same sector, Eartham Co and Iping Co. Each company has a 31 December year end.
Discuss the benefits and drawbacks of the dividend policies which the three companies appear to have adopted. Provide relevant calculations to support your discussion.
Note: Up to 5 marks are available for the calculations.
Discuss how the market capitalisation of the three companies compares with your valuations calculated using the dividend valuation model. Use the data provided to calculate valuations based on growth rates for the most recent year and for the last three years.
Note: Up to 5 marks are available for the calculations.
Use of dividend valuation model
Chithurst Co
Valuation = 33/0·11 = $300m
Chithurst Co’s market capitalisation of $608m is considerably in excess of the valuation suggested by the dividend valuation model. This may suggest that investors have some positive expectations about the company and the lower cost of equity compared with the other two companies suggests it is regarded as a more stable investment. Investors could also be valuing the company using earnings growth rather than dividend growth. However, the lower market capitalisation compared with the other two companies and the smaller increase in share price suggest that investors have higher expectations of long-term growth from Eartham Co and Iping Co.
Eartham Co
Eartham Co’s market capitalisation is closer to the valuation suggested by the dividend growth model using the one-year growth rate between 2014 and 2015 rather than the three-year growth rate between 2012 and 2015. This, together with the recent increase in share price, suggests that Eartham Co’s shareholders have an optimistic view of its ability to sustain the profit growth and hence the dividend growth of the last two years, although its higher cost of equity than the other companies suggests that they are more wary about the risks of investing in Eartham Co. It indicates confidence in the directors’ strategy, including the investments they have made.
Iping Co
