CHAPTER EIGHTEEN EARNINGS

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

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

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

THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT n has two flows 3 the stream of expected earnings 3 the expected net investment required to produce such earnings

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

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

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

THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT n ISSUING STOCK rather than debt ( which increases the D/E ratio), stock allows greater dividends to the stockholders

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

THE DIVIDEND DECISION n EXAMPLE: Consider Mr. Jones who ownes 1% of a firm A’s common stock Assume the firm follows the policy E = D + I then, Jones dividend =.01 D

THE DIVIDEND DECISION n EXAMPLE: Consider Mr. Jones who ownes 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 n 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 n 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: 3 No matter what the firm’s dividend policy, Jones is still able to spend the same amount on consumption

THE DIVIDEND DECISION n EARNINGS DETERMINE MARKET VALUE the aggregate market value of equity is equal to 3 Present Value of expected earnings 3 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 n DIVIDEND POLICY most firms keep dollar amount of dividends constant over time larger earnings may increase dividends

DETERMINANTS OF DIVIDENDS n DIVIDEND POLICY Lintner Model: 3 models behavior implied by a constant long- run target payout ratio of dividends

DETERMINANTS OF DIVIDENDS n DIVIDEND POLICY Lintner Model: 3 Let P = payout ratio goal of the firm 3 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 n DIVIDEND POLICY Lintner Model: 3 the larger the current earnings, the larger the change in dividends, but 3 the larger the previous period’s dividends, the smaller the change in dividends

THE INFORMATION CONTENT OF DIVIDENDS n DIVIDEND CHANGES MAY BE A SIGNALING DEVICE Signaling 3 an increase means management is optimistic about future earnings 3 investors raise their earnings expectations

THE INFORMATION CONTENT OF DIVIDENDS n DIVIDEND CHANGES MAY BE A SIGNALING DEVICE changes in dividends may be more important that the level of dividends decision

PRICE TO EARNINGS RATIOS n HISTORICAL RECORD ratio varies individually on a year to year basis general trend 3 for the S&P 500 both EPS and prices show general increases over time 3 EPS and prices do not parallel each other

PRICE TO EARNINGS RATIOS n HISTORICAL RECORD Permanent and Transitory Components of Earnings 3 reported total earnings may 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 3 varies in size from negative to positive 3 leads to a range of different P/E ratios over time 3 not correlated to a stock’s intrinsic value

PRICE TO EARNINGS RATIOS permanent: means the change may be ongoing 3 changes over time and investors revise their forecasts 3 leading to change in stock price 3 leading to change in the P/E ratio 3 therefore, the P/E ratio varies over time 3 correlated to the stock’s intrinsic value

PRICE TO EARNINGS RATIOS n 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 n EARNINGS GROWTH RATES Historically 3 no reliable predictor of future growth 3 annual reported earnings follow a random walk 3 quarterly earnings may have a seasonal component

EARNINGS ANNOUNCEMENTS AND PRICE CHANGES n 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 sever months afterward

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

END OF CHAPTER 18