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- DIVIDEND PAYMENTS RATING

**Active dividend** is defined as that part of profits that is distributed periodically to the shareholders of the company. There is another concept called **passive dividend** that has to do with contributions from partners to the company that have not yet been disbursed. This is mainly an accounting concept and we do not consider that it affects the value of a company from the point of view of an investor. From now on, when referring to dividends we will understand that it is the active dividend one, whose value is the one that captures this rating.

Although Gradement does not use the dividends in his main valuation ratings we have included this dividend rating since there are many investors who only invest in companies that pay regularly dividends. This rating provides information on the company's dividend yield. The dividend yield is compared to proxies of the natural and contractual interest rates estimated by Gradement. In this way, a value of `0` indicates that the company does not pay any dividends and a value of `10` indicates a relative very high dividend yield. The following table can guide the use of this rating:

Rating value range | Interpretation |
---|---|

0 - 0 |
The company does not pay dividends |

0 - 5 |
Low dividend yield |

5 - 7 |
Dividend yield similar to the natural interest |

7 - 10 |
High dividend yield |

This rating can be used in conjunction with the dividend payments steadiness rating to see if the current dividend level is temporary or is maintained by the company over time.

From a theoretical point of view, the only element that should be taken into account when valuing any company is its flow of dividends. The investment value of a company (and in general of any asset) is the discounted value of the future dividend flows *(Technical Note: when we speak here of value, we do not do it in the subjective economic sense, since this "value" In the economic sense it is not quantifiable, by value we refer here to fair appraisement. We use the discounted value of the dividend flow to take into account the time value of money: the same amount of money in the present is always worth more than the same amount in the future).*

Consider the following example in which we will not take into account the time value of money. Suppose a company is created at the beginning of a certain accounting period. The partners contribute 100 monetary units (m.u.) to start it. During this first accounting period the company requests additional credits, purchases assets, manufactures and sells its product. At the end of this first and only the company is liquidated, returns all loans and with the remaining capital pays a 100 m.u. active dividend to its shareholders. We now can see that the value of this company at the beginning of its activity was precisely 100 m.u. The partners contributed exactly what the company is worth and therefore have not obtained any profitability in this case. If, on the other hand, the company were to be liquidated in a hypothetical second accounting period, and it would also earn another 100 m.u. in this second period then we would have the following valuation:

- The value of the company at the begining =
`100 + 100 = 200 m.u.` - Shareholders's profitability =
`200/100 = 100%`(they have doubled their initial investment)

We can see, therefore, how the value of an investment can be calculated, exactly, as the sum of all future dividend flows. **Any other formula for calculating the value of an investment is only an approximation to this theoretical value**.

We know, therefore, how to calculate exactly the value of any investment. However we can not apply it in practice because there are two limitations that prevent its calculation at the initial moment of the investment:

- We do not know exactly what will be the dividend flow of the company from today until the moment of its liquidation
- Because of the time value of money (and in general of any asset), future money is worth less than present money. That difference is the
**interest rate**or temporal preference. Therefore, even if we knew exactly the flow of future dividends, we need to know what the temporary preference (interest rate) will be to discount (value at current prices) that dividend stream.

Therefore, it is only possible to know exactly the value of any company *ex-post*, *i.e.*, at the time of its liquidation. But if (1) we estimate what that dividend stream will be and (2) we estimate what the interest rates would be, we could a priori estimate the value of the firm. However, in practice it is very difficult to estimate both values, especially the future stream of dividends.

Some investors use this valuation model by estimating the future flow of dividends based on the recent past flow of dividends and in some assumptions about the evolution of the business. In Gradement we do not use this valuation model because:

- The amount of dividends paid is a decision based more on the policy of the company than on the economics of the business.
- The assumptions used to estimate future dividends tend to be very subjective.
- Any small variation in the assumptions used often cause huge variations in the company's estimated value.

Gradement mainly uses the model based on the free cash flow. This model solves the problem (1) above. Not so the problems (2) and (3) that are inherent to all investment models. For points (2) and (3) Gradement uses the more conservative model that considers that the company will continue to function in future exercises just as it has done in previous accounting periods.

Investors who base their investments solely on the level of dividends must take into account the problem (1) mentioned above: dividend payments are now a more political than economic decision. Companies that pay dividends often try to artificially maintain the same level of dividend payments, even in cases where profits fall, as the announcement of a reduction in dividends paid usually causes a drop in the share price quote of the company. In some cases they may even resort to paying dividends with charge, not to profits, but to the rest of assets, which means in practice the **decapitalization** of the company.