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DIVIDENDS AND EARNINGS

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STOCK VALUATION BASED ON EARNINGS

• THE DIVIDEND vs. EARNINGS CONTROVERSY– How important is the dividend decision made

by management?

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THE DIVIDEND V EARNINGS CONTROVERSY

• Miller & Modigliani (M&M) argue that the underlying source of value for a share is earnings

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THE DIVIDEND V. EARNINGS CONTROVERSY

• M&M: the dividend decision is relatively unimportant

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THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT

• has two flows• the stream of expected earnings

• the expected net investment required to produce such earnings

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THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT

• earnings are exactly equal to dividends and investment

E = D + I

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THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT

• earnings are exactly equal to dividends and investment

E = D + I

unless

E < D + I

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THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT

• which implies the firm obtained additional funds such as from the sale of stocks

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THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT

• ISSUING STOCK– rather than debt ( which increases the D/E

ratio), stock allows greater dividends to the stockholders

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THE DIVIDEND DECISION

• WHAT LEVEL OF DIVIDENDS WILL MAKE THE CURRENT STOCKHOLDERS BETTER OFF?

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THE DIVIDEND DECISION

• EXAMPLE:– Consider Mr. Jones who owns 1% of a

firm A’s common stock– Assume the firm follows the policy

E = D + I

– then, Jones’ dividend = .01D

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THE DIVIDEND DECISION

• EXAMPLE:– Consider Mr. Jones who owns 1% of a

firm A’s common stock– But:

if the firm follows the other policy

E < D + IJones must invest additional funds to maintain his 1%

ownership in Firm A

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THE DIVIDEND DECISION

• EXAMPLE:– Let F = the additional funding obtained by the

firm

E + F = D + I– then .01F is required.– Implication: the amount of the extra cash

dividend is exactly offset by the amount Jones needs to spend to maintain his 1% ownership in Firm A.

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THE DIVIDEND DECISION

• EXAMPLE:– but if the firm follow the policy

E > D + IJones must sell back stock to the firm or else end up with more than 1% ownership

– Key Idea:• No matter what the firm’s dividend policy, Jones is

still able to spend the same amount on consumption

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THE DIVIDEND DECISION

• EARNINGS DETERMINE MARKET VALUE– the aggregate market value of equity is equal to

• Present Value of expected earnings• less investment (E - I)

– the size of the dividend is not important– market value of stock is independent of the

dividend decision and– related to earnings prospects of the firm

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DETERMINANTS OF DIVIDENDS

• DIVIDEND POLICY– most firms keep dollar amount of dividends

constant over time– larger earnings may increase dividends

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DETERMINANTS OF DIVIDENDS

• DIVIDEND POLICY– Lintner Model:

• models behavior implied by a constant long-run target payout ratio of dividends

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DETERMINANTS OF DIVIDENDS

• DIVIDEND POLICY– Lintner Model:

• Let P = payout ratio goal of the firm

• total dividends paid in year t is

D = p * Ewhere D is the target dividends in year t

E is the amount of earnings annually

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DETERMINANTS OF DIVIDENDS

• DIVIDEND POLICY– Lintner Model:

• the larger the current earnings, the larger the change in dividends, but

• the larger the previous period’s dividends, the smaller the change in dividends

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THE INFORMATION CONTENT OF DIVIDENDS

• DIVIDEND CHANGES MAY BE A SIGNALING DEVICE– Signaling

• an increase means management is optimistic about future earnings

• investors raise their earnings expectations

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THE INFORMATION CONTENT OF DIVIDENDS

• DIVIDEND CHANGES MAY BE A SIGNALING DEVICE– changes in dividends may be more important

that the level of dividends decision

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PRICE TO EARNINGS RATIOS

• HISTORICAL RECORD– ratio varies individually on a year-to-year basis– general trend

• for the S&P 500 both EPS and prices show general increases over time

• EPS and prices do not parallel each other

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PRICE TO EARNINGS RATIOS

• HISTORICAL RECORD– Permanent and Transitory Components of

Earnings• reported total earnings may have two components:

– transitory: the increase or decrease is not repeated

– permanent: means the change may be ongoing

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PRICE TO EARNINGS RATIOS

– transitory: the increase or decrease is not repeated

• varies in size from negative to positive

• leads to a range of different P/E ratios over time

• not correlated to a stock’s intrinsic value

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PRICE TO EARNINGS RATIOS

– permanent: means the change may be ongoing• changes over time and investors revise their

forecasts

• leading to change in stock price

• leading to change in the P/E ratio

• therefore, the P/E ratio varies over time

• correlated to the stock’s intrinsic value

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PRICE TO EARNINGS RATIOS

• permanent: means the change may be ongoing– over time P/E ratios tend to revert to an average

ratio for the whole market

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RELATIVE GROWTH RATES OF A FIRM’S EARNINGS

• EARNINGS GROWTH RATES– Historically

• no reliable predictor of future growth

• annual reported earnings follow a random walk

• quarterly earnings may have a seasonal component

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EARNINGS ANNOUNCEMENTS AND PRICE CHANGES

• ANNOUNCEMENTS– stock prices tend to correctly anticipate

earnings announcements beforehand

– prices react correctly but not fully afterward

– prices continue to move in a direction similar to their initial reaction for several months afterward

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EARNINGS ANNOUNCEMENTS AND PRICE CHANGES

• ANNOUNCEMENTS– analysts do better than sophisticated mechanical

models in forecasting– analysts tend to overestimate when forecasting