Download the dollar amount of a firm`s investment

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
THE DIVIDEND V.
EARNINGS CONTROVERSY

M&M: the dividend decision is relatively
unimportant
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 INVESTMENT

earnings are exactly equal to dividends
and investment
E = D + I
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 INVESTMENT

which implies the firm obtained
additional funds such as from the sale
of stocks
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

WHAT LEVEL OF DIVIDENDS WILL
MAKE THE CURRENT STOCKHOLDERS
BETTER OFF?
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 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 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 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 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

DIVIDEND POLICY
• most firms keep dollar amount of dividends
constant over time
• larger earnings may increase dividends
DETERMINANTS OF
DIVIDENDS

DIVIDEND POLICY
• Lintner Model:
models behavior implied by a constant longrun target payout ratio of dividends
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
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

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 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

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
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
RATIOS
• transitory:
repeated
the increase or decrease is not
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
RATIOS
• permanent:
ongoing
means the change may be
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
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

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

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 CHANGES

ANNOUNCEMENTS
• analysts do better than sophisticated
mechanical models in forecasting
• analysts tend to overestimate when
forecasting
END OF CHAPTER 18