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Donald R. Van Deventer, Ph.D.

Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura.

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04/16/2014 11:02 AM

Traditional analysis of common stocks uses a wide array of financial ratios to measure value. One of the ratios most often discussed is the dividend yield on a stock. In this note we explain why the dividend yield ignores credit risk. We show that a credit-adjusted dividend yield provides much greater insight to the likely dividend return to common stock investors, as we explained in a recent note on General Electric Company (GE). Using the example of Comcast Corporation (CMCSA), we show that the long-term credit-adjusted dividend ratio is 1.61%, not the commonly quoted 1.86%. The credit-adjusted dividend yield allows investors to compare dividend yields on companies of wildly varying credit risk on an apples to apples basis.

Conclusion: The bond market provides the information we need to dramatically improve on the traditional dividend yield as a measure of potential return.

As this was written, on www.SeekingAlpha.com, the key financial ratios for Comcast Corporation were summarized in this table:

The real time update of the table is readily available to the interested reader. What is the “yield” on Comcast Corporation common stock? It is simply four times the quarterly dividend rate on the stock ($0.225) divided by the current stock price ($48.41), or 4×0.225/48.41 which is 1.8591% when carried out to four decimal places. Note that the dividend yield on www.SeekingAlpha.com is adjusted with a bit of lag. There is nothing wrong with this calculation, but it is a simple calculation that makes a number of implicit assumptions that we know are false:

• That the dividend will not change in perpetuity, continuing as a quarterly payment of $0.225 forever. That is, the dividend will not be increased, decreased, or eliminated. • That Comcast Corporation will never go bankrupt. • That no adjustment for the risk of bankruptcy is useful in understanding the risk and return on the common stock. The dividend yield calculation is mathematically identical to the yield on a consol or perpetual bond. For background on such calculations, see Chapter 4 of Advanced Financial Risk Management . In the bond market, as we explained in our detailed analysis of the bonds issued by Comcast Corporation yesterday, the idea that an investor should ignore the credit risk of a promise to pay is just a bad joke. We incorporate an evaluation of Comcast Corporation’s forecast (not promise) to pay a dividend using insights from yesterday’s bond market analysis. Credit Spreads and the Value of a Promise to Pay$1
Yesterday’s study incorporated Comcast Corporation bond price data as of April 14, 2014. A total of 93 trades were recorded on 19 Comcast Corporation bond issues with a trading volume of $40 million. What is the value of a promise by Comcast Corporation to pay$1 at a future date to a bond investor? We addressed this issue last week in a note on the credit-adjusted dividend yield for General Electric Company . Yesterday’s study shows that the promise by Comcast Corporation to pay $1 is worth considerably less than the promise of the U.S. Treasury to pay$1 on the same date. Put differently, to raise a fixed amount of money today in return for a promise to pay $1 later, Comcast Corporation pays a significant spread above and beyond the yield on a comparable promise by the U.S. Treasury. That premium was documented in this graph derived from the 93 bond trades from April 14: We are going to use this data to derive the value today of a forecast (explicit, like an announced dividend, or implicit, like the assumption the dividend will be paid in perpetuity) by Comcast Corporation to pay$1 dollar (or $0.225, or some other amount) at a date in the future. We remind readers that dividends go up, and dividends go down. The Comcast Corporation website documents nicely that the quarterly dividend payment can vary dramatically. After a very large cash dividend paid on May 6, 1999, Comcast did not pay a dividend again until 2008. Since then, the quarterly dividend has risen from$0.0625 paid on March 31, 2008 to its current $0.225 level beginning on April 23, 2014. To keep today’s analysis simple, we assume that management intends to pay a dividend of$0.225 each quarter forever unless bankruptcy makes that impossible. This is the same assumption that the traditional dividend yield calculation implies, except that the risk of bankruptcy is ignored in the traditional calculation.

To calculate the present value of the forecast to pay $0.225 each quarter in the future, we need the present value of a$1 to be paid on any future date that reflects the credit risk of Comcast Corporation. The bond market provides a ready source of such data, as yesterday’s analysis showed. We recognize that a dividend can be increased or it can be cut (as GE has done) without triggering bankruptcy, so the dividend risk facing common shareholders is higher than the coupon risk facing bond holders. We ignore this difference in risk as a first approximation in calculating a credit-adjusted dividend yield.

We get the present value factors (“zero coupon bond prices”) by following these steps:

• Smooth the U.S. Treasury curve as in the weekly Kamakura Corporation interest rate analysis to get the present value factors for a promise to pay by the U.S. Treasury
• Calculate the risk premium in a promise to pay by Comcast Corporation that minimizes the trade-weighted errors in estimated bond prices using the 19 traded bonds from April 14, 2014.

This chart shows the best fitting “zero coupon bond yields” for Comcast Corporation on April 14, 2014. The accuracy in fitting bond prices was 98.76% (adjusted r-squared of a non-linear regression).

We can calculate the present value factors from these continuously compounded yields using a spreadsheet-friendly formula in Chapter 4 of Advanced Financial Risk Management. This allows us to calculate the present value, over various time horizons, of the “constant dividend forecast” by Comcast Corporation. We show the first twelve months of that calculation in this table:

The present value of a forecasted payment by Comcast Corporation of $0.225 in 1 month, 4 months, 7 months and 11 months is$0.8979 (this is the sum of the 4 present values in the right hand column). The present value of such payments for 10 years ahead is $7.8956 and for 30 years ahead it is$15.1639. This analysis allows a common stock investor to make a “break-even” forecast for the common stock price at the end of each time horizon and compare the value of that break-even forecast with the current $48.41 stock price of Comcast Corporation. More importantly, we can ask this question: what constant quarterly amount, if promised by the U.S. Treasury, has the same present value as the$0.8979 one year present value of CMCSA dividends? The answer is $0.2245 (which is the present value of$0.8979 divided by the sum of the four relevant zero coupon bond prices of the U.S. Treasury in the middle column). This figure, $0.2245, is the credit-adjusted dividend payment by Comcast Corporation. If we multiply by 4 and divide by the$48.41 stock price, we get a 1 year credit-adjusted dividend yield of 1.8553%. This isn’t much different from the standard dividend yield, but the difference becomes very large as we extend the time horizon. The credit-adjusted dividend for a 10 year horizon is $0.2171 and for a 30 year horizon it is$0.1943. The 10 year credit-adjusted dividend yield is 1.7940% and the 30 year credit-adjusted dividend yield is 1.6055%, a full 0.25% below the nominal dividend yield. Why does the credit-adjusted dividend yield vary by maturity? For the same reason bond yields vary by maturity: the time value of money and the default risk over that horizon are very important.

The gaps between the nominal dividend yield and the long-term credit adjusted dividend yields can be very large for highly troubled companies. As we mentioned in our note on GE dividends, imagine the gap for Lehman Brothers on September 12, 2008. Equity investors have been ignoring the data used by bond investors to evaluate a similar set of promises to pay, one promise called a dividend and one called interest or principal. The credit-adjusted dividend yield helps to close the information gap between bond investors and common stock investors, and we highly recommend the calculation to serious investors.

Technical Note
The U.S. Treasury zero coupon bond yields were created using the maximum smoothness forward rate approach of Adams and van Deventer [1994], as corrected in van Deventer and Imai [1996] and reproduced in Chapter 5 of Advanced Financial Risk Management. Eleven smooth curves were fit to connect the 11 maturity points in the yield curve data released daily by the U.S. Department of the Treasury via the H15 statistical release of the Board of Governors of the Federal Reserve. On top of this smooth “base” yield curve, we fit the maximum smoothness credit spread for Comcast Corporation using six smooth credit spread curves at “knot points” chosen on the basis of the most heavily traded Comcast Corporation bonds on April 14, 2014. The analysis was done using 93 trades on 19 Comcast Corporation bond issues with a trading volume of \$40 million. Using this technique to minimize trade-weighted errors in valuing Comcast Corporation bonds, we were able to explain 98.76% of the variation in the pricing on the 19 bonds.

Author’s Note
Regular readers of these notes are aware that we generally do not list the major news headlines relevant to the firm in question. We believe that other authors on SeekingAlpha, Yahoo, at The New York Times, The Financial Times, and the Wall Street Journal do a fine job of this. Our omission of those headlines is intentional. Similarly, to argue that a specific news event is more important than all other news events in the outlook for the firm is something we again believe is inappropriate for this author. Our focus is on current bond prices, credit spreads, and default probabilities, key statistics that we feel are critical for both fixed income and equity investors.