dividends and stock earnings
TRANSCRIPT
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DIVIDENDS AND EARNINGS
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STOCK VALUATION BASED ON EARNINGS
• THE DIVIDEND vs. EARNINGS CONTROVERSY– How important is the dividend decision made
by management?
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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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THE DIVIDEND V. EARNINGS CONTROVERSY
• M&M: the dividend decision is relatively unimportant
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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
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THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT
• earnings are exactly equal to dividends and investment
E = D + I
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THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT
• earnings are exactly equal to dividends and investment
E = D + I
unless
E < D + I
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THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT
• which implies the firm obtained additional funds such as from the sale of stocks
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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
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THE DIVIDEND DECISION
• WHAT LEVEL OF DIVIDENDS WILL MAKE THE CURRENT STOCKHOLDERS BETTER OFF?
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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
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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 + IJones must invest additional funds to maintain his 1%
ownership in Firm A
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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.
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THE DIVIDEND DECISION
• EXAMPLE:– but if the firm follow the policy
E > D + IJones 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
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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
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DETERMINANTS OF DIVIDENDS
• DIVIDEND POLICY– most firms keep dollar amount of dividends
constant over time– larger earnings may increase dividends
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DETERMINANTS OF DIVIDENDS
• DIVIDEND POLICY– Lintner Model:
• models behavior implied by a constant long-run target payout ratio of dividends
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DETERMINANTS OF DIVIDENDS
• DIVIDEND POLICY– Lintner Model:
• Let P = payout ratio goal of the firm
• total dividends paid in year t is
D = p * Ewhere D is the target dividends in year t
E is the amount of earnings annually
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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 several months afterward
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EARNINGS ANNOUNCEMENTS AND PRICE CHANGES
• ANNOUNCEMENTS– analysts do better than sophisticated mechanical
models in forecasting– analysts tend to overestimate when forecasting