DIVIDENDS AND EARNINGS CHAPTER SIXTEEN DIVIDENDS AND EARNINGS

STOCK VALUATION BASED ON EARNINGS THE DIVIDEND vs. EARNINGS CONTROVERSY How important is the dividend decision made by management?

THE DIVIDEND V EARNINGS CONTROVERSY Miller & Modigliani (M&M) argue that the underlying source of value for a share is earnings

THE DIVIDEND V. EARNINGS CONTROVERSY M&M: the dividend decision is relatively unimportant

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

THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT earnings are exactly equal to dividends and investment E = D + I

THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT earnings are exactly equal to dividends and investment E = D + I unless E < D + I

THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT which implies the firm obtained additional funds such as from the sale of stocks

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

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

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

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 + I Jones must invest additional funds to maintain his 1% ownership in Firm A

THE DIVIDEND DECISION E + F = D + I 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.

THE DIVIDEND DECISION E > D + I EXAMPLE: but if the firm follow the policy E > D + I Jones 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

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

DETERMINANTS OF DIVIDENDS DIVIDEND POLICY most firms keep dollar amount of dividends constant over time larger earnings may increase dividends

DETERMINANTS OF DIVIDENDS DIVIDEND POLICY Lintner Model: models behavior implied by a constant long-run target payout ratio of dividends

DETERMINANTS OF DIVIDENDS DIVIDEND POLICY Lintner Model: Let P = payout ratio goal of the firm total dividends paid in year t is D = p * E where D is the target dividends in year t E is the amount of earnings annually

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

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

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

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

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

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

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

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

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

EARNINGS ANNOUNCEMENTS AND PRICE CHANGES 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

EARNINGS ANNOUNCEMENTS AND PRICE CHANGES analysts do better than sophisticated mechanical models in forecasting analysts tend to overestimate when forecasting