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CHAPTER EIGHTEEN. EARNINGS. STOCK VALUATION BASED ON EARNINGS. THE DIVIDEND V 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.

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CHAPTER EIGHTEEN


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stock valuation based on earnings
STOCK VALUATION BASED ON EARNINGS
  • THE DIVIDEND V EARNINGS CONTROVERSY
    • How important is the dividend decision made by management?
the dividend v earnings controversy
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 controversy4
THE DIVIDEND V. EARNINGS CONTROVERSY
  • M&M: the dividend decision is relatively unimportant
the dollar amount of a firm s investment
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 investment6
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 investment7
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 investment8
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 investment9
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
THE DIVIDEND DECISION
  • WHAT LEVEL OF DIVIDENDS WILL MAKE THE CURRENT STOCKHOLDERS BETTER OFF?
the dividend decision11
THE DIVIDEND DECISION
  • 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 = .01D
the dividend decision12
THE DIVIDEND DECISION
  • 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 decision13
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.
the dividend decision14
THE DIVIDEND DECISION
  • 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 decision15
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
DETERMINANTS OF DIVIDENDS
  • DIVIDEND POLICY
    • most firms keep dollar amount of dividends constant over time
    • larger earnings may increase dividends
determinants of dividends17
DETERMINANTS OF DIVIDENDS
  • DIVIDEND POLICY
    • Lintner Model:
      • models behavior implied by a constant long-run target payout ratio of dividends
determinants of dividends18
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 dividends19
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
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 dividends21
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
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 ratios23
PRICE TO EARNINGS RATIOS
  • HISTORICAL RECORD
    • Permanent and Transitory Components of Earnings
      • reported total earnings may two components:
        • transitory: the increase or decrease is not repeated
        • permanent: means the change may be ongoing
price to earnings ratios24
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 ratios25
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 ratios26
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
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
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 sever months afterward
earnings announcements and price changes29
EARNINGS ANNOUNCEMENTS AND PRICE CHANGES
  • ANNOUNCEMENTS
    • analysts do better than sophisticated mechanical models in forecasting
    • analysts tend to overestimate when forecasting