The Myth of the Earnings Yield
Essay written by Sam Vaknin
Sam Vaknin's Psychology, Philosophy, Economics and Foreign Affairs Web Sites
A very slim minority of firms distribute dividends. This truism has revolutionary implications. In the absence of dividends, the foundation of most - if not all - of the financial theories we employ in order to determine the value of shares, is falsified. These theories rely on a few implicit and explicit assumptions:
(a) That the (fundamental) "value" of a share is closely correlated (or even equal to)
its market (stock exchange or transaction) price
(b) That price movements (and volatility) are mostly random, though correlated to the
(fundamental) "value" of the share (will always converge to that "value" in the long
term)
(c) That this fundamental "value" responds to and reflects new information efficiently
(old information is fully incorporated in it)
Investors are supposed to discount the stream of all future income from the share (using one of a myriad of possible rates - all hotly disputed). Only dividends constitute meaningful income and since few companies engage in the distribution of dividends, theoreticians were forced to deal with "expected" dividends rather than "paid out" ones. The best gauge of expected dividends is earnings. The higher the earnings - the more likely and the higher the dividends. Even retained earnings can be regarded as deferred dividends. Retained earnings are re-invested, the investments generate earnings and, again, the likelihood and expected size of the dividends increase. Thus, earnings - though not yet distributed - were misleadingly translated to a rate of return, a yield - using the earnings yield and other measures. It is as though these earnings WERE distributed and created a RETURN - in other words, an income - to the investor.
The reason for the perpetuation of this misnomer is that, according to all current theories of finance, in the absence of dividends - shares are worthless. If an investor is never likely to receive income from his holdings - then his holdings are worthless. Capital gains - the other form of income from shareholding - is also driven by earnings but it does not feature in financial equations.
Yet, these theories and equations stand in stark contrast to market realities.
People do not buy shares because they expect to receive a stream of future income in the form of dividends.
... of owning them, but because we want to obtain profits from our original stock prices.
Berk, J., & DeMarzo, P. (2011). Corporate finance: The core, second edition. (2nd ed.). Boston, MA: Prentice Hall.
Miller and Modigliani 1961 paper states; under certain assumptions and perfect capital markets if few assumptions can be made dividend policy is irrelevant to share value (Corporate Management 3rd Edition) The determinant of the companies value will be shown by how many positive NPV projects are available with the pattern of dividends making no difference to the acceptance of the projects...
Every action or proposal needs to balance equity and efficiency needs in order to deliver optimal dividends to its targeted audience. Given the fact that resources are relatively scarce compared to the innumerable needs, businessmen, economists, administrators among other leaders reckon that every proposals needs the equity-efficiency balance in order for set goals and objectives to be achieved. This paper seeks to describe the role of equity and efficiency trade off in proposals.
Investors buy stock for one of two reasons; either it will grow in value or pay a dividend. If a company stops growing, stockholders will demand a dividend. If they don't get it, they will sell their stock. In the history, Microsoft enjoyed incredible growth, so dividend was unnecessary. Recent Microsoft dividends may tell us that the company has ended its growth phase and is now a 'mature' company.
Dividends is used often with the stock market, dividends are profit you receive when the company makes a profit. If the company does not make a profit, you will not receive a dividend reimbursement. Payments can be reinvested, which helps build wealth because you are increasing your portfolio. You can also so use this cash for whatever you like.
Accounting profit can serve as an alternative to intrinsic value. But Buffett states that “...we do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.” Accounting reality was conservative, backward looking, and governed by GAAP (measures in terms of net profit), therefore Buffett rejects this alternative. According to the world’s most famous investor, investment decisions should be based on economic reality, not on accounting
Ownership dispersion hypothesis explains that underpricing is used to insure oversubscription of the shares issues. Booth and Chua (1996) and Brennan and Franks (1997) argue that firms have the incentive to underprice shares with the aim to create a diffuse ownership base and improve market liquidity of their shares. Thus ownership structure increases the difficulty for outsiders to challenge the board of management (Mai, T.L. 2011).
Is The Tyranny Of Shareholder Value Finally Ending? N.p., n.d. Web. The Web.
The perceived benefits of dividends are not seen as much than before, other reasons like lower transactions costs for selling tocks, governance techniques to reduce the reliance on dividends as a means of corporate discipline, and clientele effect that some stockholders prefer capital gain over
The financial manager is responsible for giving financial advice and support to clients and colleagues that will enable them to make good business decisions. Particular work environments differ considerable and involve both public and private sector organizations such as retailers, corporations, financial institutions, charities, and even small manufacturing companies and schools (Financial Manager, 2011).
In mid September 2005, Ashley Swenson, the chief financial officer of this large CAD/CAM equipment manufacturer must decide whether to pay out dividends to the firm¡¦s shareholders or repurchase stock. If Swenson chooses to pay out dividends, she must also decide on the magnitude of the payout. A subsidiary question is whether the firm should embark on a campaign of corporate-image advertising and change its corporate name to reflect its new outlook. The case serves a review of the many practical aspects of the dividend and share buyback decisions, including(1) signaling effects, (2) clientele effects, and (3) finance and investment implications of increasing dividend payout and share repurchase decisions.
A generation ago, it was generally believed that security markets were efficient in adjusting information about individual stocks and stock market as a whole (Malkiel, (2003)). However, we cannot deny the efficient market hypothesis has several paradoxes.
There is a sense of complexity today that has led many to believe the individual investor has little chance of competing with professional brokers and investment firms. However, Malkiel states this is a major misconception as he explains in his book “A Random Walk Down Wall Street”. What does a random walk mean? The random walk means in terms of the stock market that, “short term changes in stock prices cannot be predicted”. So how does a rational investor determine which stocks to purchase to maximize returns? Chapter 1 begins by defining and determining the difference in investing and speculating. Investing defined by Malkiel is the method of “purchasing assets to gain profit in the form of reasonably predictable income or appreciation over the long term”. Speculating in a sense is predicting, but without sufficient data to support any kind of conclusion. What is investing? Investing in its simplest form is the expectation to receive greater value in the future than you have today by saving income rather than spending. For example a savings account will earn a particular interest rate as will a corporate bond. Investment returns therefore depend on the allocation of funds and future events. Traditionally there have been two approaches used by the investment community to determine asset valuation: “the firm-foundation theory” and the “castle in the air theory”. The firm foundation theory argues that each investment instrument has something called intrinsic value, which can be determined analyzing securities present conditions and future growth. The basis of this theory is to buy securities when they are temporarily undervalued and sell them when they are temporarily overvalued in comparison to there intrinsic value One of the main variables used in this theory is dividend income. A stocks intrinsic value is said to be “equal to the present value of all its future dividends”. This is done using a method called discounting. Another variable to consider is the growth rate of the dividends. The greater the growth rate the more valuable the stock. However it is difficult to determine how long growth rates will last. Other factors are risk and interest rates, which will be discussed later. Warren Buffet, the great investor of our time, used this technique in making his fortune.
Yet, if the investors buy a stock with the aim of receiving the long-term dividends from the ownership of the stocks then they are investing.