1. DIVIDENDS AND EARNINGS
CHAPTER SIXTEEN
DIVIDENDS AND EARNINGS

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

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

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

5. 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

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

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

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

9. 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

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

11. 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

12. 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

13. 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.

14. 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

15. 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

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

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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

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