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CHAPTER SIXTEEN
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 + I
Jones 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+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
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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*E
where 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
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