Dividends And Stock Earnings

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Dividends And Stock Earnings

  1. 1. DIVIDENDS AND EARNINGS
  2. 2. STOCK VALUATION BASED ON EARNINGS <ul><li>THE DIVIDEND vs. EARNINGS CONTROVERSY </li></ul><ul><ul><li>How important is the dividend decision made by management? </li></ul></ul>
  3. 3. THE DIVIDEND V EARNINGS CONTROVERSY <ul><li>Miller & Modigliani (M&M) argue that the underlying source of value for a share is earnings </li></ul>
  4. 4. THE DIVIDEND V. EARNINGS CONTROVERSY <ul><li>M&M: the dividend decision is relatively unimportant </li></ul>
  5. 5. THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT <ul><li>has two flows </li></ul><ul><ul><ul><li>the stream of expected earnings </li></ul></ul></ul><ul><ul><ul><li>the expected net investment required to produce such earnings </li></ul></ul></ul>
  6. 6. THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT <ul><li>earnings are exactly equal to dividends and investment </li></ul><ul><ul><li>E = D + I </li></ul></ul>
  7. 7. THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT <ul><li>earnings are exactly equal to dividends and investment </li></ul><ul><ul><li>E = D + I </li></ul></ul><ul><ul><li>unless </li></ul></ul><ul><ul><li>E < D + I </li></ul></ul>
  8. 8. THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT <ul><li>which implies the firm obtained additional funds such as from the sale of stocks </li></ul>
  9. 9. THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT <ul><li>ISSUING STOCK </li></ul><ul><ul><li>rather than debt ( which increases the D/E ratio), stock allows greater dividends to the stockholders </li></ul></ul>
  10. 10. THE DIVIDEND DECISION <ul><li>WHAT LEVEL OF DIVIDENDS WILL MAKE THE CURRENT STOCKHOLDERS BETTER OFF? </li></ul>
  11. 11. THE DIVIDEND DECISION <ul><li>EXAMPLE: </li></ul><ul><ul><li>Consider Mr. Jones who owns 1% of a </li></ul></ul><ul><ul><li>firm A’s common stock </li></ul></ul><ul><ul><li>Assume the firm follows the policy </li></ul></ul><ul><ul><li>E = D + I </li></ul></ul><ul><ul><li>then, Jones’ dividend = .01 D </li></ul></ul>
  12. 12. THE DIVIDEND DECISION <ul><li>EXAMPLE: </li></ul><ul><ul><li>Consider Mr. Jones who owns 1% of a </li></ul></ul><ul><ul><li>firm A’s common stock </li></ul></ul><ul><ul><li>But: </li></ul></ul><ul><ul><ul><li>if the firm follows the other policy </li></ul></ul></ul><ul><ul><ul><ul><li>E < D + I </li></ul></ul></ul></ul><ul><ul><ul><li>Jones must invest additional funds to maintain his 1% ownership in Firm A </li></ul></ul></ul>
  13. 13. THE DIVIDEND DECISION <ul><li>EXAMPLE: </li></ul><ul><ul><li>Let F = the additional funding obtained by the firm </li></ul></ul><ul><ul><li>E + F = D + I </li></ul></ul><ul><ul><li>then .01F is required. </li></ul></ul><ul><ul><li>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. </li></ul></ul>
  14. 14. THE DIVIDEND DECISION <ul><li>EXAMPLE: </li></ul><ul><ul><li>but if the firm follow the policy </li></ul></ul><ul><ul><li>E > D + I </li></ul></ul><ul><ul><li>Jones must sell back stock to the firm or else end up with more than 1% ownership </li></ul></ul><ul><ul><li>Key Idea: </li></ul></ul><ul><ul><ul><li>No matter what the firm’s dividend policy, Jones is still able to spend the same amount on consumption </li></ul></ul></ul>
  15. 15. THE DIVIDEND DECISION <ul><li>EARNINGS DETERMINE MARKET VALUE </li></ul><ul><ul><li>the aggregate market value of equity is equal to </li></ul></ul><ul><ul><ul><li>Present Value of expected earnings </li></ul></ul></ul><ul><ul><ul><li>less investment (E - I) </li></ul></ul></ul><ul><ul><li>the size of the dividend is not important </li></ul></ul><ul><ul><li>market value of stock is independent of the dividend decision and </li></ul></ul><ul><ul><li>related to earnings prospects of the firm </li></ul></ul>
  16. 16. DETERMINANTS OF DIVIDENDS <ul><li>DIVIDEND POLICY </li></ul><ul><ul><li>most firms keep dollar amount of dividends constant over time </li></ul></ul><ul><ul><li>larger earnings may increase dividends </li></ul></ul>
  17. 17. DETERMINANTS OF DIVIDENDS <ul><li>DIVIDEND POLICY </li></ul><ul><ul><li>Lintner Model: </li></ul></ul><ul><ul><ul><li>models behavior implied by a constant long-run target payout ratio of dividends </li></ul></ul></ul>
  18. 18. DETERMINANTS OF DIVIDENDS <ul><li>DIVIDEND POLICY </li></ul><ul><ul><li>Lintner Model: </li></ul></ul><ul><ul><ul><li>Let P = payout ratio goal of the firm </li></ul></ul></ul><ul><ul><ul><li>total dividends paid in year t is </li></ul></ul></ul><ul><ul><ul><li>D = p * E </li></ul></ul></ul><ul><ul><ul><li>where D is the target dividends in year t </li></ul></ul></ul><ul><ul><ul><li>E is the amount of earnings annually </li></ul></ul></ul>
  19. 19. DETERMINANTS OF DIVIDENDS <ul><li>DIVIDEND POLICY </li></ul><ul><ul><li>Lintner Model: </li></ul></ul><ul><ul><ul><li>the larger the current earnings, the larger the change in dividends, but </li></ul></ul></ul><ul><ul><ul><li>the larger the previous period’s dividends, the smaller the change in dividends </li></ul></ul></ul>
  20. 20. THE INFORMATION CONTENT OF DIVIDENDS <ul><li>DIVIDEND CHANGES MAY BE A SIGNALING DEVICE </li></ul><ul><ul><li>Signaling </li></ul></ul><ul><ul><ul><li>an increase means management is optimistic about future earnings </li></ul></ul></ul><ul><ul><ul><li>investors raise their earnings expectations </li></ul></ul></ul>
  21. 21. THE INFORMATION CONTENT OF DIVIDENDS <ul><li>DIVIDEND CHANGES MAY BE A SIGNALING DEVICE </li></ul><ul><ul><li>changes in dividends may be more important that the level of dividends decision </li></ul></ul>
  22. 22. PRICE TO EARNINGS RATIOS <ul><li>HISTORICAL RECORD </li></ul><ul><ul><li>ratio varies individually on a year-to-year basis </li></ul></ul><ul><ul><li>general trend </li></ul></ul><ul><ul><ul><li>for the S&P 500 both EPS and prices show general increases over time </li></ul></ul></ul><ul><ul><ul><li>EPS and prices do not parallel each other </li></ul></ul></ul>
  23. 23. PRICE TO EARNINGS RATIOS <ul><li>HISTORICAL RECORD </li></ul><ul><ul><li>Permanent and Transitory Components of Earnings </li></ul></ul><ul><ul><ul><li>reported total earnings may have two components: </li></ul></ul></ul><ul><ul><ul><ul><li>transitory : the increase or decrease is not repeated </li></ul></ul></ul></ul><ul><ul><ul><ul><li>permanent : means the change may be ongoing </li></ul></ul></ul></ul>
  24. 24. PRICE TO EARNINGS RATIOS <ul><ul><li>transitory : the increase or decrease is not repeated </li></ul></ul><ul><ul><ul><li>varies in size from negative to positive </li></ul></ul></ul><ul><ul><ul><li>leads to a range of different P/E ratios over time </li></ul></ul></ul><ul><ul><ul><li>not correlated to a stock’s intrinsic value </li></ul></ul></ul>
  25. 25. PRICE TO EARNINGS RATIOS <ul><ul><li>permanent : means the change may be ongoing </li></ul></ul><ul><ul><ul><li>changes over time and investors revise their forecasts </li></ul></ul></ul><ul><ul><ul><li>leading to change in stock price </li></ul></ul></ul><ul><ul><ul><li>leading to change in the P/E ratio </li></ul></ul></ul><ul><ul><ul><li>therefore, the P/E ratio varies over time </li></ul></ul></ul><ul><ul><ul><li>correlated to the stock’s intrinsic value </li></ul></ul></ul>
  26. 26. PRICE TO EARNINGS RATIOS <ul><li>permanent : means the change may be ongoing </li></ul><ul><ul><li>over time P/E ratios tend to revert to an average ratio for the whole market </li></ul></ul>
  27. 27. RELATIVE GROWTH RATES OF A FIRM’S EARNINGS <ul><li>EARNINGS GROWTH RATES </li></ul><ul><ul><li>Historically </li></ul></ul><ul><ul><ul><li>no reliable predictor of future growth </li></ul></ul></ul><ul><ul><ul><li>annual reported earnings follow a random walk </li></ul></ul></ul><ul><ul><ul><li>quarterly earnings may have a seasonal component </li></ul></ul></ul>
  28. 28. EARNINGS ANNOUNCEMENTS AND PRICE CHANGES <ul><li>ANNOUNCEMENTS </li></ul><ul><ul><li>stock prices tend to correctly anticipate earnings announcements beforehand </li></ul></ul><ul><ul><li>prices react correctly but not fully afterward </li></ul></ul><ul><ul><li>prices continue to move in a direction similar to their initial reaction for several months afterward </li></ul></ul>
  29. 29. EARNINGS ANNOUNCEMENTS AND PRICE CHANGES <ul><li>ANNOUNCEMENTS </li></ul><ul><ul><li>analysts do better than sophisticated mechanical models in forecasting </li></ul></ul><ul><ul><li>analysts tend to overestimate when forecasting </li></ul></ul>

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