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Share valuations

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How tax distorts the value of shares

Quite incredible that a share may be worth 50% more to one person than another, merely as a result of distortions caused by our tax system (& before you take a pot shot at our strange leaders, note that this level of stupidity in tax design isn't unique to South Africa). Suffice to say it is simply not possible to give quality investment advice without considering an individual's tax situation.

Let's consider how much tax each of the following 3 individuals pay:

 

Interest income

Capital Gains

Dividends

Mrs Retirement Fund

0%

0%

0%

John Ordinary
(25% marginal rate)

0% (hasn't utilised his tax-free interest exemption)

8.325% (25% * 33.3%)

15%

Richie Sexwale

40% (his marginal rate)

13.32% (40% * 33.3%)

15%

Setting the scene: risk-free returns & cashflows

Assume any investor can earn a gross of tax risk-free return of 7.5% p.a. in perpetuity. This means that by investing R100 our 3 individuals can generate the following guaranteed cashflows, net of tax:

 

Annual net of tax income from R100 investment

Mrs Retirement Fund

R7.50

John Ordinary

R7.50

Richie Sexwale

R4.50 (60% of R7.50)

Another way of saying this is that an annual guaranteed net of tax income of R7.50 is worth R100 to Mrs Retirement Fund & John Ordinary, whilst a net of tax income of only R4.50 a year is worth R100 to Richie Sexwale.

Investment opportunity in OnlyPaysDividends

It just so happens that all 3 of our individuals are considering investing in OnlyPaysDividends Limited. OnlyPaysDividends currently is paying dividends of R1, and this is expected to increase at a nominal rate of 8% p.a. going into the future (i.e. R1 this year, R1.08 next year, R1.17 the following year, ....). There is expected to be no gain in the value of the stock.

While the analyst has an idea of future dividends from OnlyPaysDividends, these are by no means certain. To compensate for the risk of OnlyPaysDividends expected earnings not realising, all 3 individuals agree that they require a 7% higher return (net of tax) to entice them to invest in OnlyPaysDividends rather than the alternative of 7.5% p.a. gross risk-free cashflows.

Valuations of OnlyPaysDividends

 

Required return

Net of tax Dividend Stream

Discounted value of dividends

Mrs Retirement Fund

14.5% (7.5% + 7%)

R1, R1.08, R1.17, ...

R17.62

John Ordinary

14.5% (7.5% + 7%)

R0.85, R0.92, R0.99, ...

R14.98

Richie Sexwale

11.5% (4.5% + 7%)

R0.85, R0.92, R0.99, ...

R27.08

We can see that OnlyPaysDividends is most valuable to Richie Sexwale. Although Richie Sexwale receives a 15% smaller dividend stream than Mrs Retirement Fund (who pays no dividends tax), his risk free rate is 3% smaller making the stock far more valuable to him. The higher your rate of tax on interest income, the more valuable a dividend stream is relatively to interest income. A dividend stream is worth the least to an individual who has a marginal tax greater than zero but hasn't yet utilised his tax-free interest exemption (15% less than it is worth to a retirement fund).

Valuations of PaysNoDividends

PaysNoDividends is a company which pays no dividends, but whose share price is expected to increase at such at rate that it is possible to disinvest an amount equal to R1 this year, and increasing by 8% p.a. going into the future in perpetuity. For simplicity of argument, let's assume capital gains tax applies throughout (i.e. ignore the fact that theoretically you may have to pay income tax on realisations in the first few years).

 

Required return

Net of tax realisation stream

Discounted value

Mrs Retirement Fund

14.5% (7.5% + 7%)

R1, R1.08, R1.17, ...

R17.62

John Ordinary

14.5% [7.5% + 7%]

R0.92, R0.99, R1.07, ...

R16.15

Richie Sexwale

11.5% [4.5% + 7%]

R0.87, R0.94, R1.01, ...

R27.61

You can see that retirement funds are indifferent between receiving their return as dividends or capital gain. Individuals with low marginal tax rates would far rather receive their return in the form of capital gains, and even individuals at a 40% marginal rate have a slight preference for capital gains as opposed to dividends.

Main conclusion

A share may be worth 50% more to Richie Sexwale than to Mrs Retirement Fund, but worth the least to John Ordinary.

Different valuations leads to higher volatility

If all investors have the same valuation of a share (ceteris paribus) there theoretically should be no changes in share prices until there's more information released about the share.

However, if investors value the share at different values, there would be shifts in the share prices depending on changes in the relative proportions of the various groups investing in the share.

Setting up a system with different valuations as a result of taxation differences, introduces unecessary volatility. It also means that companies may make decisions based on tax rather than what makes business sense.

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